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# "Complex" Real Options - Title Page - MIT

"Complex" Real Options - Title Page - MIT

MathematicalClassificationSimulationOptionPricingMethodMonte Carloor othersimulation ofstochasticPDEDescription Strengths WeaknessesA simulation ofthe underlyingprice. MonteCarlo is themost popularmethod,combiningthousands ofsimulations torepresent thestochastic natureof the price.Relatively easy to use andrequiring low mounts ofmathematical skill andknowledge. Manysoftware packages areavailable to conduct MonteCarlo analysis. Can beused to simulate optionprices when multipleunderlying or non-constantparameters are present.Can be computationally intensive. Maynot be theoretically precise.2.4.4 Generating Real Option Parameter ValuesWhen using standard valuation techniques for real options, one of the largest difficultiesis with the determination of values for the parameters used in solving for the option price.The five parameters, listed Table 2-2, all present various degrees of difficulty inquantification. The problems stem from the change in application, i.e. moving fromfinancial options to real options. Many of the assumptions and data sources that are usedin obtaining these values when finding the price of financial options either do not exist orneed to be modified for real options. This section deals with the various methodsavailable for generating values for the five parameters above. First a brief overview ofeach of the five parameters is given, followed by an overview of the different methodsavailable for finding values for these parameters.2.4.4.1 Overview of the Five ROA ParametersTable 2-2 lists the five parameters used in real options valuations are: current price,volatility, time to expiration, strike price, and interest rate.Table 2-2 Five parameters used in real option valuation techniques.SσRDT= value of the underlying asset= volatility or standard deviation of the underlying variable= continuously compounding risk-free rate of return= continuous dividend payouts= time until payoutValue of underlying asset - The value of the underlying asset refers to the underlyingasset that the real option provides an option on. In financial option theory the underlyingasset, or just underlying, is a stock and the current value (or price) of the underlying istherefore the current price of the stock. In real options valuation, this is perhaps thehardest of all parameters to determine. The reason for this is that to determine a currentvalue of an underlying, an appropriate underlying must first be determined.56

For some real options this appears deceptively easy. For example, if we want an optionto purchase land that can be used for petroleum production, it would seem that the properunderlying would be the price of petroleum on the open market. Therefore, if petroleumprices increase, the potential value of the field increases (i.e. the potential to sell more oilat a higher price), the option would be exercised and oil wells would be drilled.However, even oil prices on the open market may not be an appropriate underlying, asthe type of oil may differ from the composite oil prices that are listed.Unfortunately, most real options problems are not even this straight-forward. The properchoice of an underlying for most options is very difficult. For example, suppose wewanted an option on whether to build a subway system in a city. What would be a goodunderlying that would indicate if the new subway additions should be built or not?Number of subway travelers? Number of public transportation travelers? Total numberof travelers? Property value prices? Cost of building a subway system? Cost ofproviding other modes of transportation? All of these ways of measure, and more, wouldgo into any decision made for building a subway system. Is one of these more importantthan the others and should therefore become the underlying? Unlike financial options,there is no clear choice on what the underlying is so that a current value can be obtained.A common, though not uncontroversial method, of obtaining an underlying asset isthrough the Mutual Asset Disclaimer (MAD) method, where the object itself with noflexibility included is used as the underlying asset. The rationale here is that the NPV ofthe project without flexibility is the best approximation of what the project would fetchon the open market if it were put up for sale (Brealey and Myers 2003, Copeland andAntikarov 2003).Most real options theory discusses the choice of one underlying. In the above subwayexample, it is clear that multiple factors would affect any decision on whether to build thesubway or not. This seems to point to the need for an analysis that takes into accountmultiple criteria when used to value the option and when creating decision rules on whento purchase and when to exercise the option. Also, since the factors that are important formaking the decision to build a subway vary from city to city, from country to country andfrom time to time, there could be a necessity for the choice of an appropriate set ofcriteria to be dependant on the specific application.Volatility - Volatility is another difficult to quantify parameter that is open tointerpretation. Ideally, the volatility provides a measure or bound of uncertainty involvedwith the underlying asset. The difficulty comes with how to measure this volatility.Should it be a historical measure taken since the beginning of the creation of theunderlying? Or should it be only the more recent volatility – like the volatilityexperienced over the last several years, which may be a better indicator of future events.In complex systems, especially those that deal with the political domain, sudden jumpscan also occur, such as from a change in regulation, that makes modeling the volatilitymore challenging. Luerman suggests three approaches to modeling volatility; historicaldata, simulation and educated estimates (Luerman 1998). Copeland and Antikarov and57

• Page 7 and 8: ACKNOWLEDGEMENTSThis dissertation i
• Page 9: students. I am sure I am missing pe
• Page 12 and 13: 6.7 Enterprise and Institutional Ch
• Page 14 and 15: Table 8-8 Summary of existing mode
• Page 16 and 17: Figure 3-17 System management loop
• Page 18 and 19: Figure 5-13 Historical world annual
• Page 20 and 21: Figure 7-19 Decision path for ITS m
• Page 22 and 23: Figure 10-3 Summary of differences
• Page 24 and 25: 1. A large commercial aircraft maki
• Page 26 and 27: made to the system are often not on
• Page 28 and 29: From the MIT Engineering Systems Di
• Page 30 and 31: enterprise, the enterprise itself m
• Page 32 and 33: system capable of coping with uncer
• Page 34 and 35: Ch. 2Ch. 3Ch. 4Ch. 7Ch. 5Ch. 8Ch. 6
• Page 36 and 37: applicability of the framework. Fin
• Page 38 and 39: Myers, S. (1977) Determinants of Ca
• Page 40 and 41: FindingsFigure 2-1 Research process
• Page 42 and 43: • Difficult to predict future beh
• Page 44 and 45: As is apparent in the literature, t
• Page 46: of these. Ideally, either with the
• Page 49 and 50: do not appear to be mutually exclus
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• Page 53 and 54: price (the option price) for the fl
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• Page 61 and 62: 2.5 REAL OPTION PROCESSESExisting p
• Page 63 and 64: option is then evaluated with a “
• Page 65 and 66: • Option to engage in exploration
• Page 67 and 68: elatively straight-forward and are
• Page 69 and 70: OptionComplexityReal option in syst
• Page 71 and 72: 2.8 REFERENCESAllen, T. et. al. (20
• Page 73 and 74: Hayes, R. and D. Garvin. (1982) Man
• Page 75 and 76: Ross, A. (2006) Managing Unarticula
• Page 77 and 78: 3 LIFE-CYCLE FLEXIBILITY (LCF) FRAM
• Page 79 and 80: 3.1 OVERVIEW OF NEED FOR LIFE-CYCLE
• Page 81 and 82: Figure 3-3 Condensed version of the
• Page 83 and 84: level, the appropriate enterprise n
• Page 85 and 86: 3.1.2.1 Conceiving an OptionThe abi
• Page 87 and 88: 3.1.2.2 Design and Evaluation of Op
• Page 89 and 90: option holder can not exercise the
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• Page 93 and 94: 3.2.2 DECISION TO USE LCF FRAMEWORK
• Page 95 and 96: Figure 3-11 Integration of decision
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Figure 3-16 illustrates how the str

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3.2.6 MANAGING THE SYSTEMManaging t

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System Management LoopFigure 3-17 S

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System Management LoopSystemImpleme

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Long-term Management Loop ofUnknown

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Long-term Management Loop of Unknow

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Figure 3-23 Condensed LCF Framework

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3.4 REFERENCESAllen, T. et. al. (20

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4 FLEXIBILITY IN BLENDED WING BODY

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4.1.1 THE EARLY YEARSAfter the firs

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Figure 4-2 Sikorsky S-42 Flying Boa

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The 1950’s saw aircraft shift fro

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to the government for doing so, wou

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Figure 4-7 European supersonic civi

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While airlines compete on a variety

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Figure 4-11 Comparison of several l

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Figure 4-12 Foreign and domestic so

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Figure 4-14 Drawings from Leonardo

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shifting their body weight) to the

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Figure 4-19 Semi-monocoque construc

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With a bi-wing (or tri-wing) constr

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Figure 4-24 Loads and lifts generat

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Figure 4-25 747-8, showing both loc

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Additional benefits of the BWB arch

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4.4.1 BWB OPTION DECISION PATHSFor

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lower costs, higher scales of econo

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Miller, B. (2005) A Generalized Rea

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5 VALUE OF FLEXIBILITY IN BLENDED W

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This chapter is composed of three m

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this research were deemed necessary

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For clarity of discussion, a high l

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model, a better understanding of co

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An overview of each of these subsys

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important and may make inroads into

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Figure 5-9 Airline finances and pro

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Figure 5-10 Airline profitability,

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Product design is based on a trade-

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The airframe manufacturer productio

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5.2.5 MODEL VALIDATIONThe system dy

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Forecast data (all planes)Model dat

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5.3.1 INHERENT BENEFITSBWB technica

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minor differences between aircraft

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The remainder of this section looks

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derivative depends on corporate str

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Table 5-1 Number of derivatives lik

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LowFuelCosts35%30%HighFuelCostsProb

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The results presented can be interp

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Compared to the Boeing 787, the dev

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than a European option, because of

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In the opposite case where the BWB

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Because of the consequences of exer

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35%30%Probability25%20%15%10%5%0%\$-

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BWB does not seem to offer advantag

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type plane, relative to conventiona

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5.4 REFERENCESAirbus. (2006) Annual

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6 CHALLENGES OF FLEXIBILITY IN BLEN

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FindingsFigure 6-1 Case study analy

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Figure 6-2 Characteristics of case

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6.1.3 INTERVIEWEE SELECTIONAs the i

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Table 6-2 ITS case study organizati

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about flexibility, i.e. is it a goo

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2. If flexibility is used, can you

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case with BCA, which has embraced a

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primarily through military and NASA

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Figure 6-7 Delivery and market fore

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to meet rising demand, the overall

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Another option widespread in the ai

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design, evaluate or manage flexibil

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Interviewee views on flexibility ce

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and evaluations are based around th

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operating and maintenance costs by

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when fuel costs increased substanti

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options, such as cross-program deri

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6.9 REFERENCESAirbus. (2007) Produc

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7 FLEXIBILITY IN HOUSTON GROUNDTRAN

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Figure 7-2 Characteristics of case

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cases can be added to existing or n

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7.2.2 STANDARD ITS TECHNOLOGIES AND

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• increased opportunities for pri

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for Inherently Low Emitting Vehicle

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Marker 2005). This type of cross fu

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Figure 7-4 Plastic pylon separated

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ecause the network of sensors can t

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DSRC based system would require a l

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Houston has already deployed one of

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Figure 7-13 Transit center location

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Figure 7-15 Houston’s managed lan

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as HOT or TOT lanes. This can be es

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HOT / BRTlaneNon-flexibleTOT / BRTl

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or improved safety functions could

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Haning, C. and W. McFarland. (1963)

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8 VALUE OF FLEXIBILITY IN HOUSTON G

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attempt was made to completely repr

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Figure 8-4 Quantitative analysis pr

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8.2.1.1 Travel Demand ModelingThe t

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ange of traffic analysis studies to

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I-10 KatyFreewayI-610(innerloop)Bel

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5 lanesFigure 8-10 Example of satel

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Beltway 8(secondary loop)I-610 (inn

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8.2.2.5 Major Modeling AssumptionsD

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from a public agency that is intere

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funding improvements that would pre

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This is because of the low-cost of

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From the analysis above, with the d

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Figure 8-16 Addition of two general

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capabilities are typically deployab

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Table 8-5 Benefit-Cost Ratios for K

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35%30%25%Probability20%15%10%5%0%\$(

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Figure 8-20 NPV density function, w

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Table 8-6 Summary of flexibility to

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Figure 8-23 Comparison of ITS/delay

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vehicles would continue to gain fre

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Figure 8-24 Value of time savings f

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This illustrates the importance of

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Table 8-10 Summary of ITS case stud

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Similar to the above discussion of

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9 CHALLENGES OF FLEXIBILITY IN HOUS

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new challenges as well as increase

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9.2 QUALITATIVE ANALYSIS PROCESSPre

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The qualitative research methodolog

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to be able to answer the research q

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Table 9-1 Functional activities per

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USDOT, Volpe Center, Officeof Syste

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3. If flexibility is used, can you

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• Increased data sources - The no

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importance that Harris County plays

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Figure 9-7 H-GAC area of responsibi

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Figure 9-9 State level stakeholders

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9.3.2.3 State Legislators and Gover

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The resulting plan forecasted more

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Discussions with interviewees with

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Currently, the cross section of the

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Also of interest is another part of

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y the Southern Pacific Railroad. In

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9.6 PROCESSES FOR IDENTIFYING, DESI

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The federal level interviewee conti

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may not be tied to a physical proje

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During the interview process, sever

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Figure 9-15 Katy Freeway configurat

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Monitor/ManageFigure 9-16 Summary o

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company on a schedule to complete t

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interviewees commented on the ongoi

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facilities has created a lack of wi

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eversible HOV lanes as a safety pre

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the real option and the decision to

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• Mechanism for creating pressure

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9.9.2.2 Uncertainty as a Result of

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option purchase price. This was bec

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9.10 REFERENCESABC7. (2004) Chicago

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Judd, D. and T. Swanstrom. (2004) C

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10 FINDINGS AND CONCLUSIONSChapter

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concerns the use of real options

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Table 10-1 Summary of major researc

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to a system. Rather, these options

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future option exercise can prevent

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Q1-2. The case studies provided a d

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Currently, the Silver Line right-of

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technical system as well as the soc

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In the ITS case study, the transpor

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system that the technical system is

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option exercise unlikely (building

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some future date. This type of wast

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DesignPhaseEvaluationPhaseManagemen

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ITS capabilities used to create the

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technical and social components of

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incorporated directly into the mode

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As defined in Section 2.6, the diff

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In the BWB case study, an enterpris

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For “standard” real options it

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“Standard” real options are des

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From the research it was found that

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d. Evaluating the option with quant

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need for the system is, while simul

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10.7 REFERENCESClemons, E. and B. G

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