Real Options Analysis

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SDWA has carried and is carrying out research projects in the field of real options analysis in systems design. Real options can be used to value flexibilities in designs of complex systems. Research at SDWA aims at developing real options methodologies and applying it to case studies.

Background & Scope

Real Options in Systems Design

Many large-scale systems require huge initial outlays, have consequences stretched well into the future, and face inevitably a great deal of uncertainty. However, managers often tend to adopt a single scenario for the future, come up with a fixed design and compute a single performance measure for a project. Ex ante design decisions are based on forecasts that are “always wrong”. If reality departs in one way or another from what was originally anticipated the design ends up in a sub-optimal configuration. While system failures or sub-optimal configurations arise from many sources, they can be attributed to a large extent to the fact that analysis have either not incorporated risks and uncertainty in the process, or have failed to create plans to address the issue of uncertainty in the design and management of systems.

Moreover, the conventional notion that risk is undesirable and must therefore be minimised is inadequate for system design. Risk and uncertainty also provide opportunities. It is important to reduce downside losses, but capture upward opportunities. This can be done through incorporating flexibility so that the system can be changed according how the future unfolds. Such flexibilities related to systems and projects are known as real options.

Incorporating flexibility – a real option – into a system, comes, however, at a cost, because it may involve additional capabilities, smaller stages investments and missing out on economies of scale, or it may cause delays. The questions thus are: What is the value of the different forms of flexibility that may be added to a system? And which real options justify their costs?

SDWA’s real options research projects so far are:

  • Dynamic Strategic Planning: Real Options Analysis for a Maritime Domain Protection System against Piracy and Terrorism
  • Singapore’s Water Supply System – A Real Options Analysis

Researchers

Researchers involved in Real Options Analysis are: Stephen Zhang, Vladan Babovic, Joost Buurman and Laurence Chan.

Interesting Observations / Key Findings

Dynamic Strategic Planning: Maritime Domain Protection System

(Project carried out from February 2008 РFebruary 2008 with support from Defence Science & Technology Agency (DSTA), Singapore)

Complex engineering systems are usually designed to last for many years. Such systems will face many uncertainties in the future. Hence the design and deployment of these systems should not be based on a single scenario, but should incorporate flexibility. Flexibility can be incorporated in system architectures in the form of options that can be exercised in the future when new information is available. Incorporating flexibility comes, however, at a cost. To evaluate if this cost is worth the investment a real options analysis can be carried out. This approach is demonstrated through analysis of a case study of a previously developed static system-of-systems for maritime domain protection in the Straits of Malacca. This article presents a framework for dynamic strategic planning of engineering systems using real options analysis and demonstrates that flexibility adds considerable value over a static design. In addition to this it is shown that Monte Carlo analysis and genetic algorithms can be successfully combined to find solutions in a case with a very large number of possible futures and system designs.

Real Options Analysis for a Water Supply System

(Part of PhD study currently being carried out)

Water supply has increasingly become a struggle for nearly all the populous places in the world. Conventional water resources cannot meet the water requirements of the dense populations and industries in urban cities. The problem is further amplified by various uncertainties. As one of the more water-stressed countries, Singapore has limited conventional water resources and progressively architects its water supply system through acquiring and sustaining multiple (alternative) water resources. The full rationale and merits of such a policy cannot be properly understood based on traditional project valuation methods alone, and this paper provides the decision support for the policy by evaluating alternative water resources from multiple perspectives under uncertainties.

This study demonstrates that incorporating alternative water resources can concurrently improve the water supply system from financial, political and socioeconomic perspectives. Alternative water resources provide flexibilities to the water supply system, and are fundamental and effective means to deal with risk. The evaluation of alternative water resources in an integrated real options approach in the local contexts gives specific tangible accounts of the values of the alternative water resources, and complements the general prescriptive Integrated Water Resources Management (IWRM) framework in architecting water supply system under uncertainty.

 

Publications
Journal Papers

  • Buurman J., Zhang S., Babovic V., Reducing Risk Through Real Options in Systems Design: The Case of Architecting a Maritime Domain Protection System, Risk Analysis, vol. 29, Issue 3, pp 366-379. Abstract

Conference Papers

  • Zhang S. and V. Babovic, Architecting Water Supply System – A Perspective From Value Of Flexibility, Second International Symposium on Engineering Systems, MIT, June 15-17, 2009.
  • Zhang S. and V. Babovic, Multiple-Objective Decision-Support Using A Real Option Approach – A Case Study Of Singapore Water Supply System, 33rd IAHR 2009 Congress – Water Engineering for a Sustainable Environment, 2009 .
  • Zhang, Stephen, Joost Buurman, and Vladan Babovic, Design of a Maritime Security System under Uncertainty Using an Evolutionary Real Options Approach, 12th Annual International Real Options Conference, Rio de Janeiro, 2008.