Recent estimates suggest that the cost of developing a single new drug in the biopharmaceutical sector is $2.6 billion, confirming the very large amounts of money that medical companies invest to develop a new treatment. Biomedical companies also face the risk of very low rates of success, not only due to the inherent scientific risk of developing new drugs, but also due to the risk of the Food and Drug Administration’s (FDA) regulatory approval process. The question that ought to be asked is what financial markets can do to promote more efficient risk sharing in the healthcare and drug development areas from which our societies can benefit. This is the question investigated by Adam Jørring, Andrew Lo, Tomas Philipson, Manita Singh, and Richard Thakor in their paper “Sharing R&D Risk in Healthcare via FDA Hedges.” They address the problem highlighted by many in the medical fields that investors are unwilling to provide financing due to these risks, resulting in a “funding gap” and underinvestment in biomedical R&D that causes many potentially valuable drugs either not being realized or not pursued beyond a certain stage. The authors propose a new form of financial instrument, FDA hedges, which allow biomedical R&D investors to share the pipeline risk associated with the FDA approval process with capital markets. Such instruments are shown to avoid the market failure that leads to an R&D “funding gap.” Using FDA approval data, the authors discuss the pricing of FDA hedges and mechanisms by which they can be traded and use novel panel dataset of FDA approval probabilities to explore the risks inherent in these contracts. The paper finds evidence that the risk associated with FDA hedges is mostly idiosyncratic, and argue that these instruments are appealing to both investors and issuers. Ultimately, FDA hedges should accelerate the development of new biomedical products by providing the necessary funding to support such risky projects, and will undoubtedly improve the health of countless patients. The significant social welfare implications are very clear for all of us.
Spotlight by Andrew Ellul
Photos courtesy of Adam Jørring, Andrew W. Lo, Tomas J. Philipson, Manita Singh, and Richard T. Thakor
First published December 10, 2021