Time consistency (finance)


Time consistency in the context of finance is the property of not having mutually contradictory evaluations of risk at different points in time. This property implies that if investment A is considered riskier than B at some future time, then A will also be considered riskier than B at every prior time.

Time consistency and financial risk

Time consistency is a property in financial risk related to dynamic risk measures. The purpose of the time the consistent property is to categorize the risk measures which satisfy the condition that if portfolio is riskier than portfolio at some time in the future, then it is guaranteed to be riskier at any time prior to that point. This is an important property since if it were not to hold then there is an event such that B is riskier than A at time although it is certain that A is riskier than B at time. As the name suggests a time inconsistent risk measure can lead to inconsistent behavior in financial risk management.

Mathematical definition

A dynamic risk measure on is time consistent if and implies.

Equivalent definitions

; Equality
; Recursive
; Acceptance Set
; Cocycle condition

Construction

Due to the recursive property it is simple to construct a time consistent risk measure. This is done by composing one-period measures over time. This would mean that:

Value at risk and average value at risk

Both dynamic value at risk and dynamic average value at risk are not a time consistent risk measures.

Time consistent alternative

The time consistent alternative to the dynamic average value at risk with parameter at time t is defined by
such that.

Dynamic superhedging price

The dynamic superhedging price is a time consistent risk measure.

Dynamic entropic risk

The dynamic entropic risk measure is a time consistent risk measure if the risk aversion parameter is constant.

Continuous time

In continuous time, a time consistent coherent risk measure can be given by:
for a sublinear choice of function where denotes a g-expectation. If the function is convex, then the corresponding risk measure is convex.