FDA Hedges: A Proposal to Better Share R&D Risks

Posted 19 April 2017 By Zachary Brennan

The probability that an investigational drug will succeed in all three phases of clinical trials and win US Food and Drug Administration (FDA) approval is very low. So low, in fact, that a group of economists have written a new paper calling for a system whereby developers could hedge their research and development (R&D) risks by buying options that would pay companies a pre-specified amount in the event that a treatment fails a given phase of the FDA approval process.

The idea is that by allowing companies to purchase these so-called “exchange-traded FDA binary options,” companies would be further encouraged to invest in R&D, according to the authors of the paper, Adam Jørring of the University of Chicago, Andrew Lo of the Massachusetts Institute of Technology, Tomas Philipson of the University of Chicago, Manita Singh of Goldman Sachs and Richard Thakor of the University of Minnesota.

“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,” they write, noting that the high risks of new treatment development slow down innovation.

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The authors use historical FDA approval data to discuss the pricing of FDA hedges and mechanisms for their trading, in addition to estimates of returns.

For instance, if a company is developing a new oncology drug that has made it to a Phase 2 clinical trial, the company could buy an option for $737,000, and if the treatment fails in the trial, the company would recoup $1 million (though if the treatment made it past Phase 2, the company would lose the $737,000). Prices for other options in the proposal are featured below.

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“The prices of the single-phase options correspond directly to the failure rates in each phase,” the authors note. “In particular, the price to purchase an option at the beginning of phase 2 to insure against phase 2 failure is significantly higher than the price to purchase options at the beginning of the other phases. This reflects the fact that the failure rates in the development process for the various disease groups are the highest in phase 2.”

The authors also calculated multiple-phase FDA binary options, though, as some have already noted, the developer would have an advantage because of its intimate knowledge of the data.  

“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,” the authors added.

Sharing R&D Risk in Healthcare via FDA Hedges

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Categories: Biologics and biotechnology, Drugs, Ethics, News, US, FDA, Business and Leadership

Tags: R&D risk, pharmaceutical risks, FDA hedges

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