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Conditional expectation

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1.1 General denition

Recall the denition of conditional probability associated with Bayes Rule

P(A|B)

P(A B)

P(B)

For a discrete random variable X we have

P(A) =

x

P(A, X = x) =

x

P(A|X = x)P(X = x)

and the resulting formula for conditional expectation

E(Y |X = x) =

_

Y ()P(dw|X = x)

=

_

X=x

Y ()P(dw)

P(X = x)

=

E(Y 1

(X=x)

)

P(X = x)

We would like to extend this to handle more general situations where densities

dont exist or we want to condition on very complicated sets.

Denition 1 Given a random variable Y with E|Y | < dened on a prob-

ability space (, A, P) and some sub--eld G A we will dene the con-

ditional expectation as the almost surely unique random variable E(Y |G)

which satises the following two conditions

1. E(Y |G) is G-measurable

2. E(Y Z) = E(E(Y |G)Z) for all Z which are bounded and G-measurable

Remark: one could replace 2. in the previous denition with:

G G, E(Y 1

G

) = E(E(Y |G)1

G

).

1 DEFINITION OF CONDITIONAL EXPECTATION 5

Proof of existence and unicity

Existence Using linearity, we need only consider X 0. Dene a

measure Q on F by Q(A) = E[X1

A

] for A F. This is trivially

absolutely continuous with respect to P

|F

, the restriction of P to F.

Let E[X|F] be the Radon-Nikodym derivative of Q with respect to

P

|F

. The Radon-Nikodym derivative is F-measurable by construction

and so provides the desired random variable.

Unicity: If Y

1

, Y

2

are two F-measurable random variables with E[Y

1

1

A

] =

E[Y

2

1

A

] for all A F, then Y

1

= Y

2

, a.s., or conditional expectation is

unique up to a.s. equivalence.

For G = (X) when X is a discrete variable, the space is simply partitioned

into disjoint sets = G

n

. Our denition for the discrete case gives

E(Y |(X)) = E(Y |X)

=

n

E(Y 1

X=xn

)

P(X = x

n

)

1

X=xn

=

n

E(Y 1

Gn

)

P(G

n

)

1

Gn

which is clearly G-measurable. In general for G = (X):

Denition 2 Conditional expectation of Y given X

Let (, A, P) be a probability space, Y L

1

(, A, P) and X another

random variable dened on (, A, P). Dene then E(Y | X) the conditional

expectation of Y given X as E(Y | (X)).

Proposition 3 Let (, A) be a measurable space,

Y L

1

(, A, P)

and X another real-valued random variable dened on (, A, P). As

X = f(Y ), where f is measurable, real-valued function if and only if (X)

(Y ), we get that E(Y | X) is a measurable function of X.

Proposition 4 Let (, A, P) be a probability space, and X and Y two in-

dependent random variables such that Y is P-integrable. Then E(Y | X) =

E(Y ), P-almost surely.

Do not mix this notion with the following:

2 PROPERTIES OF CONDITIONAL EXPECTATION 6

1.2 Couples of random variables with p.d.f.

Proposition 5 Let (X, Y ) be a couple of real-valued random variables with

p.d.f. f

X,Y

(x, y) w.r.t. the Lebesgue measure on R

2

. Denote the respective

marginal p.d.f. of X and Y as f

X

(x) and f

Y

(y). Consider f

X|Y

(x | y) =

f

X,Y

(x,y)

f

Y

(y)

. Then almost surely

C B, P(X C | Y = y) =

_

C

f

X|Y

(x | y)dx.

If besides X is P-integrable, then

E(X | Y = y) =

_

R

xf

X|Y

(x | y)dx.

If g : R

2

R is a measurable function such that g(X, Y ) is integrable, then

E(g(X, Y ) | Y = y) =

_

R

g(x, y)f

X|Y

(x | y)dx.

Remarks: As soon as f

Y

(y) > 0, this denes the distribution of X given

that Y = y, described by p.d.f f

X|Y

(x | y), which is nonnegative and of

integral 1.

If X and Y are independent, f

X|Y

= f

X

and f

Y |X

= f

Y

. To make the link

with E[X|Y ] would require to introduce the concept of regular conditional

distribution.

Equation (5) may be useful to compute the mathematical expectation of

g(X, Y ) as

E(g(X, Y )) =

_

R

__

R

g(x, y)f

X|Y

(x | y)dx

_

f

Y

(y)dy.

2 Properties of Conditional Expectation

2.1 Conditional expectation

E(|G) may be seen as an operator on random variables that transforms A-

measurable variables into G-measurable ones.

Let us recall the basic properties of conditional expectation:

2 PROPERTIES OF CONDITIONAL EXPECTATION 7

1. E(|G) is positive:

Y 0 E(Y |G) 0)

2. E(|G) is linear:

E(aX +bY |G) = aE(X|G) +bE(Y |G)

3. E(|G) is a projection:

E(E(X|G)|G) = E(X|G)

4. More generally, the tower property. If H G then

E(E(X|G)|H) = E(X|H) = E(E(X|H) | G)

Proof: The right equality holds because E[X|H] is H- measurable,

hence G-measurable. To show the left equality, let A H. Then since

A is also in G,

E[E[E[X|G]|H]1

A

] = E[E[X|G]1

A

] = E[X1

A

] = E[E[X|H]1

A

].

Since both sides are H- measurable, the equality follows.

5. E(|G) commutes with multiplication by G-measurable variables:

E(XY |G) = E(X|G)Y for E|XY | < and Y Gmeasurable

Proof: If A G, then for any B G,

E[1

A

E[X|G]1

B

] = E[E[X|G]1

AB

] = E[X1

AB

] = E[(1

A

X)1

B

].

Since 1

A

E[X|G] is G-measurable, this shows that the required equality

holds when Y = 1

A

and A G. Using linearity and taking limits shows

that the equality holds whenever Y is G-measurable and X and XY are

integrable.

2 PROPERTIES OF CONDITIONAL EXPECTATION 8

6. E(|G) respects monotone convergence:

0 X

n

X = E(X

n

|G) E(X|G)

7. If is convex (in particular if (x) = x

2

) and E|(X)| < then a

conditional form of Jensens inequality holds:

(E(X|G) E((X)|G)

8. E(|G) is a continuous contraction of L

p

for p 1:

E(X|G)

p

X

p

and

X

n

L

2

X implies E(X

n

|G)

L

2

E(X|G)

9. Repeated Conditioning. For G

0

G

1

. . ., G

= (G

i

), and X L

p

with p 1 then

E(X|G

n

)

a.s.

E(X|G

)

E(X|G

n

)

L

p

E(X|G

)

10. Best approximation property:

Suppose that the random variable X is square-integrable, but not mea-

surable with respect to G. That is, the information in G does not

completely determine the values of X. The conditional expectation,

Y = E[X | G], has the property that it is the best approximation to

X among functions measurable with respect to Y , in the least squares

sense. That is, if

Y is G-measurable, then

E

_

(

Y X)

2

_

E

_

(Y X)

2

.

It thus realizes the orthogonal projection of X onto a convex closed

subset of a Hilbert space. This predicts the variance decomposition

theorem that we shall see in a further section.

2 PROPERTIES OF CONDITIONAL EXPECTATION 9

2.2 Conditional variance

Denition 6 Let X be a square-integrable, real-valued random variable de-

ned on a probability space (, A, P), and let F be a sub--algebra of A.

Dene the conditional variance of X given F (denoted by Var(X | F))

as the random variable E((X E(X | F))

2

| F).

Dene also the conditional variance of X given a real-valued random vari-

able Y dened on (, A, P) (denoted by Var(X | Y )) as the random variable

E((X E(X | Y ))

2

| Y ).

Proposition 7 Var(X | F) and Var(X | Y ) are well- dened, almost surely

nonnegative and nite.

Var(X | F) = E(X

2

| F) E(X | F)

2

,

and

Var(X | Y ) = E(X

2

| Y ) E(X | Y )

2

.

Proposition 8 Variance decomposition formula

Let (X, Y ) be a couple of random variables dened on a probability space

(, A, P), such that X is square-integrable. Then

Var(X) = E(Var(X | Y )) + Var(E(X | Y )).

This may be very useful in non-life insurance to nd the variance of a com-

pound distribution.

Proof:

Var(X | Y ) = E(X

2

| Y ) (E(X | Y ))

2

.

E[Var(X | Y )] = E[E(X

2

| Y )] E[(E(X | Y ))

2

].

E[E(X

2

| Y )] = E[X

2

].

E[Var(X | Y )] = E[X

2

] E[(E(X | Y ))

2

].

Var(E(X | Y )) = E[(E(X | Y ))

2

] (E[E(X | Y )])

2

.

E[E(X | Y )] = E[X].

Hence Var(E(X | Y )) = E[(E(X | Y ))

2

] (E[X])

2

.

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