The 'Chicken Game' And Investment Opportunities In Ukrainian Crisis

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The "Game Theory", which is based on two parties with conflicting interests, was first developed by economist John Nash, but has extensive application in international relations. Most of the games have unstable and unpredictable outcomes. Some of the most used scenarios are "Chicken Game", when two drivers head for a single-lane bridge from opposite directions. If neither swerves, they both collide. Because the costs of swerving are small, and the costs of a collision are high, each driver assumes the other will give way because that is the rational thing to do. However there are many possible outcomes like one driver swerve away, both the drivers swerve away or they smash into each other. If we think the participants are rational, the maximum loss for both the participants is the accident, and the maximum profit is the "win". Less than maximum loss is when to swerve away from course of collision. To win the game, the participant who commits himself to the game earlier; increase the speed to the point where he can not swerve, will transmit a psychological signal to the other party that only options available to the other participant are the maximum loss or less than maximum loss

So what game is being played in Ukraine right now?. Russia and West are headed to a collision course. So it is easy for both sides to imagine the other side will blink first, and give in to the demands. West and Russia both assume the other side has too much too lose to not to give in. Russia by sending its troops has upped the ante and sent out a signal that the options available to west are maximum loss (military confrontation is less likely) or sanctions. But if sanctioned, that may result in blockade of gas to Western Europe (which gets 20% of its gas from Russia's Gazprom). Russia backing down may result in loss of prestige for Putin, which may hurt its local popularity. Western Europe can not afford a stoppage of natural gas, a stick which has been wielded before. The statements from western head of states are upping the ante from the second participant in the game but not to the level of Russia. The variation of minimum loss to both the parties is a negotiated settlement of the crisis. Considering Putin's commitment to the game, that may result in a outcome with phased Russian withdrawal, constitutional rights for Crimean's to make decision, and formation of a unity government in Kiev or a combination of these scenarios. That brings me to another game scenario the "diner's dilemma." If five of us go out for dinner, the cost will be split five ways. If every one orders the most expensive dish on the menu even though it is only slightly better than the least expensive - because the extra cost is split five ways and it is a small sum. But it can result in ordering five most expensive dishes - and a more expensive night than any one wanted. The most expensive dish on Russian menu is sanctions and same may be true for Western powers. But will they order it?. The expense to each party may be different in this case. According to my read of the situation, both the parties of the "Chicken Game" will swerve away from collision, but higher speed of Putin in the game, will help him win more concessions than the other participant; the Western powers for whom compromise is cheap compared to the costs of failing to agree. The most expensive dishes may not be ordered and the West may be provided with a compromise, which will provide them with a public face saving.

What are current investing implications of most likely scenario?. Micex Index has collapsed by almost +23% in last few days. Russian natural gas giant, Gazprom ADR (OGZPY LI) has fallen by +23% and ishares Russia Index (NYSEARCA:ERUS) has gone down by +10% yesterday. Most of these investing options are trading at their all times low. If a compromise solution emerges, most of them are likely to gain +20% in a short while. The one thing that game theory teaches us, however, is that in some circumstances people do not always reach all beneficial outcomes. In fact, they quite sometimes end up with a result that is worst for all of them.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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