Value-at-Risk Analysis for Real Options in Complex Engineered Systems

This paper presents a simple but powerful Real Options Valuation methodology suitable for valuing flexibility in complex engineered systems. It is based on value-at-risk analysis and relies on a standard discounted cash flow approach. A case study on the architecting of flexible satellite fleets is presented. The architecting framework integrates spacecraft engineering design with economic analysis for the purpose of maximizing the financial value of a fleet to the operator under uncertain, evolving market conditions. The investigation considers the forecasted demand evolution for a satellite service in two distant geographical markets simultaneously and provides flexible fleet architectures that significantly improve various aspects of the value-at-risk distributions compared to those of a traditional, rigid fleet architecture. It is shown that the flexible architectures are able to capture more revenue, mitigate more risk and/or reduce overall required investment. The suggested Real Options “in” the system, rather than “on” the system, approach allows engineers, strategists, or decision makers in engineering establishments to embed flexibility in the design of complex systems for the purpose of maximizing their total lifetime value

Part 3: Systemic risk in ecology and engineering

The Federal Reserve Bank of New York released a report -- New Directions for Understanding Systemic Risk -- that presents key findings from a cross-disciplinary conference that it cosponsored in May 2006 with the National Academy of Sciences' Board on Mathematical Sciences and Their Applications. ; The pace of financial innovation over the past decade has increased the complexity and interconnectedness of the financial system. This development is important to central banks, such as the Federal Reserve, because of their traditional role in addressing systemic risks to the financial system. ; To encourage innovative thinking about systemic issues, the New York Fed partnered with the National Academy of Sciences to bring together more than 100 experts on systemic risk from 22 countries to compare cross-disciplinary perspectives on monitoring, addressing and preventing this type of risk. ; This report, released as part of the Bank's Economic Policy Review series, outlines some of the key points concerning systemic risk made by the various disciplines represented - including economic research, ecology, physics and engineering - as well as presentations on market-oriented models of financial crises, and systemic risk in the payments system and the interbank funds market. The report concludes with observations gathered from the sessions and a discussion of potential applications to policy. ; The three papers presented in this conference session highlighted the positive feedback effects that produce herdlike behavior in markets, and the subsequent discussion focused in part on means of encouraging heterogeneous investment strategies to counter such behavior. Participants in the session also discussed the types of models used to study systemic risk and commented on the challenges and trade-offs researchers face in developing their models.Financial risk management ; Financial markets ; Financial stability ; Financial crises

Optimal seismic upgrade timing in seaports with increasing throughput demand via real options

A real options (RO) formulation is proposed for decision-making on the timing to upgrade the seismic performance of existing seaports with increasing throughput demand in earthquake prone areas. The pay-off of the seismic upgrade investment option is estimated based on projected net earnings, repair cost, and downtime for a damaging reference seismic event having a pre-specified annual probability of occurrence. These projections inform a discrete-time RO binomial tree, following the American option valuation framework, which propagates the probability of the reference seismic event assuming Poisson temporal distribution of earthquake occurrence. The net present value of the expected annual payoff of the considered investment is used as an index supporting risk-informed decision-making discounted by the weighted average cost of capital (WACC). Numerical examples pertaining to decision makers with different capital cost, namely port authorities and terminal operators, operating in different economic environments typical of developed and developing countries are furnished to illustrate the applicability of the proposed RO formulation. It is found that high WACC and/or low throughput growth bring the optimal seismic upgrade timing forward, while earthquake consequences and upgrade cost have almost no influence on this timing

Considerations for a design and operations knowledge support system for Space Station Freedom

Engineering and operations of modern engineered systems depend critically upon detailed design and operations knowledge that is accurate and authoritative. A design and operations knowledge support system (DOKSS) is a modern computer-based information system providing knowledge about the creation, evolution, and growth of an engineered system. The purpose of a DOKSS is to provide convenient and effective access to this multifaceted information. The complexity of Space Station Freedom's (SSF's) systems, elements, interfaces, and organizations makes convenient access to design knowledge especially important, when compared to simpler systems. The life cycle length, being 30 or more years, adds a new dimension to space operations, maintenance, and evolution. Provided here is a review and discussion of design knowledge support systems to be delivered and operated as a critical part of the engineered system. A concept of a DOKSS for Space Station Freedom (SSF) is presented. This is followed by a detailed discussion of a DOKSS for the Lyndon B. Johnson Space Center and Work Package-2 portions of SSF

THE ECONOMICS OF AGRICULTURAL BIOTECHNOLOGY: HISTORICAL AND ANALYTICAL FRAMEWORK

In this working paper we attempt to establish a general analytical framework for the calculation of the micro- and macroeconomic benefits and costs of biotechnology applications in EU agriculture. Since these innovative applications are typically protected by intellectual property rights, standard welfare analyses will overestimate total benefits generated by these innovations. On the other hand, this doesn't mean that innovators are extracting all of the benefits. A recent ex-post welfare analysis on US Bt-cotton shows that farmers have captured the largest share of benefits (Falck-Zepeda, Traxler and Nelson, 1999). Due to the importance of intellectual property rights and the consolidation of the agricultural input industry, the framework presented by Moschini and Lapan (1997) seems to be the most adequate model as it takes into account these elements.Research and Development/Tech Change/Emerging Technologies,

Derivatives: Innovation in the Era of Financial Deregulation

This is the third of several papers examining the underlying viability of the assertion that regulation of the financial markets is unduly burdensome. These papers assert that the value of the financial markets is often mis-measured. The efficiency of the market in intermediating flows between capital investors and capital users (like manufacturing and service businesses, individuals, and governments) is the proper measure. Unregulated markets are found to be chronically inefficient using this standard. This costs the economy enormous amounts each year. In addition, the inefficiencies create stresses to the system that make systemic crises inevitable

Climate change and transport infrastructures: State of the art

Transport infrastructures are lifelines: They provide transportation of people and goods, in ordinary and emergency conditions, thus they should be resilient to increasing natural disasters and hazards. This work presents several technologies adopted around the world to adapt and defend transport infrastructures against effects of climate change. Three main climate change challenges have been examined: Air temperatures variability and extremization, water bombs, and sea level rise. For each type of the examined phenomena the paper presents engineered, and architectural solutions adopted to prevent disasters and protect citizens. In all cases, the countermeasures require deeper prediction of weather and climate conditions during the service life of the infrastructure. The experience gained supports the fact that strategies adopted or designed to contrast the effects of climate change on transport infrastructures pursue three main goals: To prevent the damages, protect the structures, and monitor and communicate to users the current conditions. Indeed, the analyses show that the ongoing climate change will increase its impact on transport infrastructures, exposing people to unacceptable risks. Therefore, prevention and protection measures shall be adopted more frequently in the interest of collective safety

Screening for Real Options “In” an Engineering System: A Step Towards Flexible System Development; PART I: The Use of Design Matrices to Create an End-to-End Representation of a Complex Socio-Technical System

The goal of this research is to develop an analytical framework for screening for real options “in” an engineering system. Real options is defined in the finance literature as the right, but not the obligation, to take an action (e.g. deferring, expanding, contracting, or abandoning) at a predetermined cost and for a predetermined time. These are called "real options" because they pertain to physical or tangible assets, such as equipment, rather than financial instruments. Real options improve a system’s capability of undergoing classes of changes with relative ease. This property is often called “flexibility.” Recently, the DoD has emphasized the need to develop flexible system in order to improve operational, technical, and programmatic effectiveness. The aim of this research is to apply real options thinking to weapon acquisitions in order to promote the ability of weapon system programs to deftly avoid downside consequences or exploit upside opportunities. The practice of real options in systems engineering is a nascent field of inquiry. One of the most significant challenges in applying real options to engineering systems is the problem of identifying the most efficacious points within the system to create options. In order to identify the points of interest, systems engineers require knowledge about the physical and non physical aspects of the system, insight into sources of change, and the ability to examine the dynamic behavior of the system. We propose a two-phase process to perform this analysis. The first phase is a system representation phase that seeks to create an end-to-end representation of engineering system that includes endogenous interactions across system views and interactions with a systems environment. The next phase is an analysis phase that models the evolution of the engineering system in order to identify the real options in the system. This paper presents the system representation phase and proposes a methodology for creating an end-to-end representation of an engineering system. The methodology for representing an engineering system extends existing systems engineering and architecting methods in two dimensions. First, the framework couples traditional architecting views to represent traceability and endogenous interactions within an engineering system. Second, the framework includes views of the system not represented in traditional engineering frameworks that includes social networks and environmental interactions. The framework uses coupled Design Structure Matrices (DSM) to represent the traditional and new architecting views. The coupled DSMs are organized into an Engineering System Matrix (ESM), which is a holistic representation of an engineering system that captures all of the critical variables and causal interactions across architectural elements. The result is an analytic framework that captures the qualitative understanding of the system into a single view that is conducive for deep quantitative inquiry. This paper presents a discussion of pertinent literature, an overview of the ESM framework and underlying theory. In addition, this paper previews ongoing research using the ESM to identify options for a mini-air vehicle (MAV) weapon development system

Screening for Real Options “In” an Engineering System: A Step Towards Flexible System Development

The goal of this research is to develop an analytical framework for screening for real options “in” an engineering system. Real options is defined in the finance literature as the right, but not the obligation, to take an action (e.g. deferring, expanding, contracting, or abandoning) at a predetermined cost and for a predetermined time. These are called "real options" because they pertain to physical or tangible assets, such as equipment, rather than financial instruments. Real options improve a system’s capability of undergoing classes of changes with relative ease. This property is often called “flexibility.” Recently, the DoD has emphasized the need to develop flexible system in order to improve operational, technical, and programmatic effectiveness. The aim of this research is to apply real options thinking to weapon acquisitions in order to promote the ability of weapon system programs to deftly avoid downside consequences or exploit upside opportunities