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(Creating independent Brownian motions to represent correlated ones). Let $B_1(t), \ldots, B_m(t)$ be $m$ one-dimensional Brownian motions with $$ d B_i(t) d B_k(t)=\rho_{i k}(t) d t \text { for all } i, k=1, \ldots, m, $$ where $\rho_{i k}(t)$ are adapted processes taking values in $(-1,1)$ for $i \neq k$ and $\rho_{i k}(t)=1$ for $i=k$. Assume that the symmetric matrix $$ C(t)=\left[\begin{array}{cccc} \rho_{11}(t) & \rho_{12}(t) & \cdots & \rho_{1 m}(t) \\ \rho_{21}(t) & \rho_{22}(t) & \cdots & \rho_{2 m}(t) \\ \vdots & \vdots & & \vdots \\ \rho_{m 1}(t) & \rho_{m 2}(t) & \cdots & \rho_{m m}(t) \end{array}\right] $$ is positive definite for all $t$ almost surely. Because the matrix $C(t)$ is symmetric and positive definite, it has a matrix square root. In other words, there is a matrix $$ A(t)=\left[\begin{array}{cccc} a_{11}(t) & a_{12}(t) & \cdots & a_{1 m}(t) \\ a_{21}(t) & a_{22}(t) & \cdots & a_{2 m}(t) \\ \vdots & \vdots & & \vdots \\ a_{m 1}(t) & a_{m 2}(t) & \cdots & a_{m m}(t) \end{array}\right] $$ such that $C(t)=A(t) A^{\operatorname{tr}}(t)$, which when written componentwise is

     (Creating independent Brownian motions to represent correlated ones). Let $B_1(t), \ldots, B_m(t)$ be $m$ one-dimensional Brownian motions with
$$
d B_i(t) d B_k(t)=\rho_{i k}(t) d t \text { for all } i, k=1, \ldots, m,
$$
where $\rho_{i k}(t)$ are adapted processes taking values in $(-1,1)$ for $i \neq k$ and $\rho_{i k}(t)=1$ for $i=k$. Assume that the symmetric matrix
$$
C(t)=\left[\begin{array}{cccc}
\rho_{11}(t) & \rho_{12}(t) & \cdots & \rho_{1 m}(t) \\
\rho_{21}(t) & \rho_{22}(t) & \cdots & \rho_{2 m}(t) \\
\vdots & \vdots & & \vdots \\
\rho_{m 1}(t) & \rho_{m 2}(t) & \cdots & \rho_{m m}(t)
\end{array}\right]
$$
is positive definite for all $t$ almost surely. Because the matrix $C(t)$ is symmetric and positive definite, it has a matrix square root. In other words, there is a matrix
$$
A(t)=\left[\begin{array}{cccc}
a_{11}(t) & a_{12}(t) & \cdots & a_{1 m}(t) \\
a_{21}(t) & a_{22}(t) & \cdots & a_{2 m}(t) \\
\vdots & \vdots & & \vdots \\
a_{m 1}(t) & a_{m 2}(t) & \cdots & a_{m m}(t)
\end{array}\right]
$$
such that $C(t)=A(t) A^{\operatorname{tr}}(t)$, which when written componentwise is
Show more…
Stochastic Calculus for Finance II : Continuous-Time Models
Stochastic Calculus for Finance II : Continuous-Time Models
Steven E. Shreve 1st Edition
Chapter 4, Problem 16 ↓

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(Creating independent Brownian motions to represent correlated ones). Let $B_1(t), \ldots, B_m(t)$ be $m$ one-dimensional Brownian motions with $$ d B_i(t) d B_k(t)=\rho_{i k}(t) d t \text { for all } i, k=1, \ldots, m, $$ where $\rho_{i k}(t)$ are adapted processes taking values in $(-1,1)$ for $i \neq k$ and $\rho_{i k}(t)=1$ for $i=k$. Assume that the symmetric matrix $$ C(t)=\left[\begin{array}{cccc} \rho_{11}(t) & \rho_{12}(t) & \cdots & \rho_{1 m}(t) \\ \rho_{21}(t) & \rho_{22}(t) & \cdots & \rho_{2 m}(t) \\ \vdots & \vdots & & \vdots \\ \rho_{m 1}(t) & \rho_{m 2}(t) & \cdots & \rho_{m m}(t) \end{array}\right] $$ is positive definite for all $t$ almost surely. Because the matrix $C(t)$ is symmetric and positive definite, it has a matrix square root. In other words, there is a matrix $$ A(t)=\left[\begin{array}{cccc} a_{11}(t) & a_{12}(t) & \cdots & a_{1 m}(t) \\ a_{21}(t) & a_{22}(t) & \cdots & a_{2 m}(t) \\ \vdots & \vdots & & \vdots \\ a_{m 1}(t) & a_{m 2}(t) & \cdots & a_{m m}(t) \end{array}\right] $$ such that $C(t)=A(t) A^{\operatorname{tr}}(t)$, which when written componentwise is
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Key Concepts

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Brownian Motion
Brownian motion is a continuous-time stochastic process with stationary independent increments and paths that are almost surely continuous. It forms the basis for modeling random behavior in various fields, particularly in finance, physics, and mathematics, and is often used to build more complex stochastic processes.
Correlation and Covariance Structure
The correlation (or covariance) structure of a set of stochastic processes specifies how the increments or values of these processes co-vary with one another. In the context of Brownian motions, a non-diagonal covariance matrix indicates that the processes are correlated, meaning that the movements in one process may systematically relate to those in another.
Positive Definite Matrices
A matrix is positive definite if it produces strictly positive quadratic forms for any nonzero vector. In the context of covariance or correlation matrices, positive definiteness ensures that the matrix corresponds to a valid, non-degenerate multivariate distribution, allowing for meaningful statistical interpretations and subsequent transformations.
Matrix Square Root
A matrix square root of a positive definite matrix is a matrix that, when multiplied by its transpose, recovers the original matrix. This concept is essential for decomposing a covariance matrix into a product of matrices, which facilitates the construction of correlated processes from independent ones via linear transformations.
Representing Correlated Brownian Motions Using Independent Ones
This approach involves expressing correlated Brownian motions as linear combinations of independent Brownian motions. By using a transformation matrix derived from the matrix square root (often obtained via methods like the Cholesky decomposition), one can map independent increments to correlated increments, preserving the desired dependence structure.

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