Sharing R&D Risk in Healthcare via FDA Hedges
51 Pages Posted: 7 Apr 2017 Last revised: 17 Apr 2017
Date Written: March 15, 2017
The high cost of capital for firms conducting medical research and development (R&D) has been partly attributed to the government risk facing investors in medical innovation. This risk slows down medical innovation because investors must be compensated for it. We propose new and simple financial instruments, Food and Drug Administration (FDA) hedges, to allow medical R&D investors to better share the pipeline risk associated with FDA approval with broader capital markets. Using historical FDA approval data, we discuss the pricing of FDA hedges and mechanisms under which they can be traded and estimate issuer returns from offering them. Using various unique data sources, we find that FDA approval risk has a low correlation across drug classes as well as with other assets and the overall market. We argue that this zero-beta property of scientific FDA risk could be a main source of gains from trade between issuers of FDA hedges looking for diversified investments and developers looking to offload the FDA approval risk. We offer proof of concept of the feasibility of trading this type of pipeline risk by examining related securities issued around mergers and acquisitions activity in the drug industry. Overall, our argument is that, by allowing better risk sharing between those investing in medical innovation and capital markets more generally, FDA hedges could ultimately spur medical innovation and improve the health of patients.
Keywords: Healthcare Finance, R&D Investments, Drug Development, FDA Approval, Idiosyncratic Risk, Risk sharing, Hedging
JEL Classification: G11, G12, G13, G22, G23, G31, I18, K23, L65, O32
Suggested Citation: Suggested Citation