Months before the Food and Drug Administration (FDA) decides to approve or reject a new drug, it often asks committees of drug experts for their recommendations. The experts receive nonpublic technical reports from drug firms and FDA staff. We find significant abnormal options trading before the final reports are created and the committees meet, particularly for small drug firms. These options trades appear to be informed because there are more calls (puts) purchased before approvals (rejections), and a majority have maturities covering the dates when the reports are publicly released. Our results imply that securities regulators should consider monitoring trades early, well before FDA drug approval decisions.

Academic researchers, as well as pharmaceutical firms themselves, often use the Capital Asset Pricing Model (CAPM) to estimate a firm's cost of capital. But the CAPM implicitly assumes that cash flows follow a random walk. This assumption is inconsistent with our finding that large U.S.-based pharmaceutical firms' cash flow growth rates display either momentum or mean-reversion. We show that growth rate momentum implies: (1) the systematic risk of a project increases monotonically with time to maturity of the cash flows; and (2) longer duration projects require a higher cost of capital. One of the practical implications of our results is that the traditional CAPM underestimates the cost of capital for some pharmaceutical firms by as much as 2.8%. These findings are quite relevant for the policy debate about the high rates of return earned by pharmaceutical companies, which some claim are pure rents and are not necessary to attract investors. Our theoretical and empirical analysis shows that high returns are often required to compensate for the higher systematic risk of long-duration pharmaceutical cash flows.