Expected Products of Correlated Geometric Brownian Motions
Summary
The document considers expected products of two correlated geometric Brownian motion processes observed at different times. It proposes decomposing their Brownian drivers into independent motions using a correlation-based representation, then using independent increments and conditional expectation to handle values across time. This framework helps distinguish when expectations factor and when shared randomness creates a covariance contribution.
The included derivation gives a conditional expectation for a forward value based on one process and computes its expectation when multiplied by the other process. For a product involving three observations, it recommends applying the tower property across the relevant time points. The material is illustrative rather than a complete treatment: it assumes constant parameters and a specified correlation structure, and the original attempt contains an unclear expression. Care is needed to track time intervals and dependence before factorizing expectations.
Key ideas
- Represent correlated Brownian drivers using independent Brownian motions and their correlation.
- Use independent increments to separate process evolution across nonoverlapping time intervals.
- Conditioning on the information available at a time gives the forward expectation of a geometric Brownian process.
- Shared Brownian shocks mean that expectations of products generally cannot be factored into separate expectations.
- Apply the tower property in stages to handle products observed at several ordered times.
Tags
Full text
# Expected Value of Products of Processes
# Expected Value of Products of Processes
Suppose I have two processes.
$A_t = A_0 \exp((a-\frac{1}{2}\sigma_A^2)t+\sigma_A W_t^A$
$B_t = B_0 \exp((b-\frac{1}{2}\sigma_B^2)t+\sigma_B W_t^B$
I would like to calculate $E[A_s B_t]$ where s < t.
Attempt:
I can rewrite $B_t$ as $B_t = B_s \exp((b-\frac{1}{2}\sigma_B^2)(t-s) + \sigma_B W_{t-s}^B)$. Then, $A_sB_t = A_sB_s\exp((b-\frac{1}{2}\sigma_B^2)(t-s) + \sigma_B W_{t-s}^B)$.
Thus, $E(A_s B_t) = E(A_s B_s)E(\exp((b-\frac{1}{2}\sigma_B^2)(t-s) + \sigma_B W_{t-s}^B))$
$= A_0 B_0 \exp((a+b+\rho\sigma_A \sigma_B)s)+\sigma(b(t-s))$.
Could anyone confirm whether this approach is correct. How would I then be able do compute $E(A_s B_t B_r)$ where $ s < t < r$. Would I simply do the same thing but use
$B_r = B_s\exp((b-\frac{1}{2}\sigma_B^2)(r-t)+\sigma_BW_{r-t}^B)\exp((b-\frac{1}{2}\sigma_B^2)(t-s)+\sigma_BW_{t-s}^B)\exp((b-\frac{1}{2}\sigma_B^2)s+\sigma_BW_{s}^B)$
My second part of this question relates to the forward. Assume $s<t<r$ and $F_{t,r}^A = E(A_r|A_t)$. How would I be able to compute $E(B_r F_{t,r}^A )$? Am I allowed to do $E(B_r)E( F_{t,r}^A )$ even though the time periods overlap because I am working with a forward?
## Answer by Gordon (score 2)
https://quant.stackexchange.com/a/25871
Based on Cholesky decomposition, \begin{align*} W_t^A &= W_t^1,\\ W_t^B &= \rho W_t^1 + \sqrt{1-\rho^2}W_t^2, \end{align*} where $(W_t^1, t \ge 0)$ and $(W_t^2, t \ge 0)$ are two independent standard Brownian motions. Then \begin{align*} A_t &= A_0\exp\Big(\big(a-\frac{1}{2}\sigma_A^2\big)t + \sigma_A W_t^1 \Big),\\ B_t &= B_0\exp\Big(\big(b-\frac{1}{2}\sigma_B^2\big)t + \sigma_B\big( \rho W_t^1 + \sqrt{1-\rho^2}W_t^2\big) \Big). \end{align*} The remaining calculation are based on this decomposition. For example, assuming that $t<r$, note that \begin{align*} A_r &= A_0\exp\Big(\big(a-\frac{1}{2}\sigma_A^2\big)r + \sigma_A W_r^1 \Big)\\ &=A_0\exp\Big(\big(a-\frac{1}{2}\sigma_A^2\big)t + \sigma_A W_t^1 + \big(a-\frac{1}{2}\sigma_A^2\big)(r-t) + \sigma_A (W_r^1-W_t^1)\Big)\\ &= A_t \exp\Big( \big(a-\frac{1}{2}\sigma_A^2\big)(r-t) + \sigma_A (W_r^1-W_t^1)\Big). \end{align*} Similarly, \begin{align*} B_r &= B_t \exp\Big( \big(b-\frac{1}{2}\sigma_B^2\big)(r-t) + \sigma_B\big[\rho (W_r^1-W_t^1) + \sqrt{1-\rho^2}(W_r^2-W_t^2)\big]\Big). \end{align*} Then, \begin{align*} F_{t, r}^A &= E(A_r\mid A_t)\\ &= A_t\exp\big(a(r-t)\big). \end{align*} Consequently, \begin{align*} E(B_r F_{t, r}^A) &=E(B_r E(A_r\mid A_t))\\ &=\exp\big(a(r-t)\big) E(B_r A_t)\\ &=\exp\big(a(r-t)\big) E\big(E(B_r A_t \mid \mathcal{F}_t)\big)\\ &=\exp\big((a+b)(r-t)\big) E(A_t B_t)\\ &=A_0B_0\exp\big((a+b)(r-t)\big) \\ &\quad E\left(\exp\Big(\big(a-\frac{1}{2}\sigma_A^2\big)t + \sigma_A W_t^1 + \big(b-\frac{1}{2}\sigma_B^2\big)t + \sigma_B\big( \rho W_t^1 + \sqrt{1-\rho^2}W_t^2\big)\Big) \right)\\ &=A_0B_0\exp\big((a+b)\,r + \rho\, \sigma_A\sigma_B\, t\big). \end{align*}
As for $E(A_sB_tB_r)$, where $s<t<r$, you can use the tower law: first consitional on $\mathcal{F}_t$ , and then conditional on $\mathcal{F}_s$.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.