The dead relative can represent an aspect of her that she reminds you of - for example, if your grandmother was very generous, she can stand for generostiy.
Or the dream can just be a reflection of how much you miss her and loved he and how she is always in your memories, even though during waking life you probably have other things occupying your mind.
It's very common to dream about dead relatives. The part of your brain that stores these memories doesn't really have a sense of time - it doesn't understand that your grandmother is now dead and the dream doesn't make sense.
When you realized in your dream that your grandmother was no longer alive, the more logical parts of your brain (the parts that have a sense of time and cause/effect - that know that after someone dies they can't live anymore) were stepping in to tell you that your grandmother couldn't really be here.
That, by the way, is often how lucid dreamers realize that they are dreaming. Something in the dream happens that isn't logically possible, and the logical parts of the brain (which remain very active during a lucid dream) step in and say that isn't possible, therefore, it must be a dream.
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