The Hedging Decision for Financial Institutions Marco Gambacciani Supervisors: Prof. Dr. Erich Walter Farkas and Dr. Pablo Koch-Medina Abstract The effect of risk management policies on ﬁrm’s value has been prominently discussed in recent studies in both theoretical and empirical corporate ﬁnance. Some attention has been given more speciﬁcally to the case of Financial Institutions. In this work my intent is to extend the existent literature on the decisions of risk management and their impact on the shareholders’ value for Financial Institutions. The main focus will be on the economic intuition underpinning Froot and Stein (1998), but departing from it by revising the main critical points, concavity of the Franchise Value and the normality assumption. The main idea of risk management for a ﬁnancial institution is to reduce the exposure of ﬁrm’s cash ﬂows to changes in ﬁnancial and also non-ﬁnancial risks, since this could jeopardize the Franchise Value. However when the level of initial equity capital is very low the effect of risk management on the Limited Liability option strikes. In this paper we will deal with the interlink between risk management, investment and capital structure decisions in the context of a ﬁnancial institution by adopting a one-period discrete model set-up. The impact of hedging decisions on the Franchise Value and on the Limited Liability option are explicitly analysed depending on different capitalization levels. We ﬁnd that the Froot and Stein (1998)’s full hedging result still hold completely only when the capital level is very high. Thus the concept of hedging risk as a shareholders’ value enhancing policy is revised beneath a capitalization condition. 1