Sharing R&D Risk in Healthcare via FDA Hedges

Biomedical innovation suffers from a "funding gap"between the needs of drug development firms and the availability of funds. The requirement of large investments for drug development projects and the high pipeline risk associated with FDA approval causes this funding gap in part. In this paper, we propose a new financial instrument - the "FDA hedge"- that pays off upon FDA approval failure. We develop a theory to show that the FDA hedge can help eliminate the funding gap. Using novel project-level data, we establish empirically that FDA hedge risk is idiosyncratic, and show how better sharing this risk can spur welfare-enhancing R&D.