Working Paper: NBER ID: w23344
Authors: Adam J. Jorring; Andrew W. Lo; Tomas J. Philipson; Manita Singh; Richard T. Thakor
Abstract: 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 analyze 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: FDA hedges; medical innovation; risk sharing; biopharmaceuticals; financial instruments
JEL Codes: G11; G12; G13; G22; G23; G31; I18; K23; L65; O32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| FDA hedges (D18) | better risk-sharing between investors and capital markets (G24) |
| better risk-sharing between investors and capital markets (G24) | increased medical innovation (O35) |
| FDA hedges (D18) | reduction of risk borne by developers (G52) |
| FDA approval risk (D18) | low correlation with other assets and market factors (G19) |
| low correlation with other assets and market factors (G19) | enhances appeal of FDA hedges as diversified investments (G40) |
| historical data supports feasibility of trading FDA hedges (G13) | market acceptance of such instruments (G10) |
| better risk-sharing (G32) | spur innovation and improve patient health outcomes (O36) |