Finance Pharmaceuticals Regulation

FDA Hedges

Pharmaceutical companies face major risk.  There is risk that the drugs they are researching don’t work (e.g., lack of efficacy) or are not safe.  There is risk that health insurers or government payers will not cover their treatment.  And there is risk that the FDA will not approve a drug after a Phase III clinical trial.

One approach to address the last source of risk is what Alex Tabarrok of Marginal Revolution calls FDA Hedges.  He explains the concept below:

In the words of a recent article, the FDA’s rejection of a recent drug application was a stunning setback. Stunning setbacks are by definition unpredictable and unpredictable risks aren’t correlated with other risks which means that they can be easily priced and bought and sold. The all-star team of Adam Jørring, Andrew W. Lo, Tomas J. Philipson, Manita Singh and Richard T. Thakor propose just this in Sharing R&D Risk in Healthcare via FDA Hedges.

The idea is to create FDA Hedges that pay out a fixed fee if a drug fails to be approved and zero otherwise. Pharmaceutical firms could then buy some of these contracts and reduce their risk exposure which in turn would increase their incentive to invest in R&D.

This concept of FDA Hedges is very novel.  However, a key question is how robust the FDA Hedges market would be.  Drug companies with insider information that their drug would fail could buy up these hedges whereas companies that have strong evidence that their drug will succeed will not buy them.  This could create adverse selection in the market whereby the FDA Hedges unravel.  In his article, Tabarrok mentions a few other reasons to be skeptical, but concludes that because R&D is so valuable, even a marginal increase in R&D would be worthwhile.


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