EFFICIENT AND EXACT SIMULATION OF THE GAUSSIAN

AFFINE INTEREST RATE MODELS (WITH APPLICATION TO

THE HULL WHITE MODEL AND G2++ MODEL)

VLADIMIR OSTROVSKI (PHD)

Abstract. The Gaussian ane interest rate models are widely used in the
nancial industry for pricing, hedging and also risk management purposes.
We consider the multifactor models with time dependent parameters. Usu-
ally the models are simulated using some appropriate discretization schema
because the joint distribution of the stochastic and discounting factors is not
known. We derive the exact joint conditional distribution of the stochastic and
discounting factors. Additionally we show how an ecient and exact Monte
Carlo simulation of the Hull White and G2++ interest rates models could be
performed.

1. Introduction

The Gaussian ane interest rate models are widely used in the nancial industry

for pricing, hedging and also risk management purposes. The important advantage

of the Gaussian ane interest rate models is that the bonds and zero bond options

can be eciently evaluated, see Due and Kan [1996], Dai and Singleton [2000],

Due et al. [2003] for more details and fairly general results. In some special

cases even closed-form pricing formulas are available. The Gaussian ane interest

rate models are often used as building blocks for other asset classes, see Brigo and

Mercurio [2006].

The models should be simulated on some time-grid t1 < . . . < tn . The conditional

distribution of the short rate r(t) is known in this case, see Lemma 1. However the

Key words and phrases. ane interest rate models, conditional distribution, Hull-White, G2++,
simulation, exact, ecient.
1

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joint distribution of r (t) and discounting factor
 ˆ t 
ϕ(t) = exp − r(u)du
0

is unknown and thus some discretization schema will be applied.

In this paper we avoid any discretization and propose an exact and ecient

simulation schema for the short rate r (t) and discounting factor ϕ(t). The stepping

error will be completely avoided and there is also strong increase in the computation

speed.

We start with the briey introduction to the Gaussian ane interest rate models

using notation from Brigo and Mercurio [2006]. Under the risk neutral measure the

instantaneous short rate is given by

d
X
(1.1) dr(t) = ϑ(t) + xi (t)
i=1

where d is dimension of the model, xi (t) are stochastic factors and the nonrandom

function ϑ(t) is chosen so as to exactly t the initial yield curve observed in the

market. The stochastic factor xi (t) evolves accordingly to the dierential equation

(1.2) dxi (t) = ai (t)xi (t)dt + σi (t)dWi (t)

where ai (t) is a time-dependent mean-reversion speed, σi (t) is a time-dependent

volatility and xi (0) = 0. The processes Wi (t) are Brownian motions following

(1.3) dWi (t)dWj (t) = ρij (t)dt

where ρij (t) is a time-dependent instantaneous correlation taking values in [−1, 1] .

The instantaneous correlation matrix (ρij (t)) should be nonnegative semidenite

for any t. The Gaussian ane models include some well known interest rate models

as for example: Vasicek model Vasicek [1977], Hull-White models Hull and White

[1990, 1993, 1996, 2001], G2++ model Brigo and Mercurio [2006, p. 142].

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 2. Efficient and exact simulation schema

We start with the joint conditional distribution of the stochastic and discounting

factors. We transform the discounting factor as follows

ˆ t ˆ t d ˆ
X t ˆ t d
X
− ln (ϕ (t)) = r (u) du = ϕ (u) du + xi (u) du = ϕ (u) du + yi (t)
0 0 i=1 0 0 i=1

where
ˆ t
(2.1) yi (t) = xi (u) du
0

is the supplemental process. Thus it is sucient to calculate the joint conditional

distribution of (x1 , . . . , xd , y1 , . . . , yd ) .

Let T be the time horizon of the model. Let the functions ai (t), σi (t) and ρij (t)

be nonrandom and continuous on the interval [0, T ] for the remainder of the paper.

The closed form solution of the dierential equation (1.2) is well known, see Lemma

1.

Lemma 1. For any 0 ≤ s < t ≤ T the solution of the dierential equation (1.2) is
given by
ˆ t  ˆ t ˆ t 
(2.2) xi (t) = xi (s) exp ai (u)du + σi (u) exp ai (v)dv dWi (u)
s s u

conditional on xi (s).

Proof. see Shreve [2004, p. 266] or Shreve and Karatzas [2002, p. 360]. 

Next we derive the exact formula for the supplemental process yi (t) conditional

on previous values xi (s) and yi (s) .

Theorem 2. Let s ∈ [0, T ) be xed and let t ∈ [s, T ] . Conditional on xi (s) and
yi (s) the supplemental process yi (t) can be represented as
ˆ t
yi (t) = yi (s) + xi (s)λi (s, t) + σi (u)λi (u, t)dWi (u)
s
3

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on the interval [s, T ] , where
ˆ t ˆ z 
λi (u, t) = exp ai (v)dv dz
u u

Proof. The proof is based on the stochastic Fubini theorem, see Veraar [2012] or
Protter [2005, Th. IV.65] for details. By denition (2.1) we obtain
ˆ t ˆ s ˆ t ˆ t
yi (t) = xi (z) dz = xi (z)dz + xi (z)dz = yi (s) + xi (z)dz
0 0 s s

We use the explicit formula (2.2) of the factor xi and then apply the stochastic

Fubini theorem as follows

ˆ t
xi (z)dz
s
ˆ t ˆ z  ˆ t ˆ z ˆ z  
= xi (s) exp ai (u)du dz + σi (u) exp ai (v)dv dWi (u) dz
s s s s u
ˆ t ˆ t ˆ z  
= xi (s) λi (s, t) + σi (u) exp ai (v)dv dz dWi (u)
s u u
ˆ t
= xi (s) λi (s, t) + σi (u)λi (u, t)dWi (u)
s

The integrability condition

ˆ T ˆ t ˆ z 2 !
σi (u) exp ai (v)dv dz du < ∞
0 s u

of the stochastic Fubini theorem is fullled because the functions σi (t) and ai (t)

are continuous and thus bounded on the interval [0, T ] . 

The stochastic factors xi (t) as well as supplemental processes yi (t) are of the

form
ˆ t
µ (s, t, xi (s), yi (s)) + σ(u, t)dW (u)
s

where σ(u, t) and µ (s, t, xi (s), yi (s)) are nonrandom continuous functions. Thus we

consider the m−dimensional process z(t) with the components

ˆ t
(2.3) zi (t) = σi (u, t)dW
fi (u)
0
4

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The Brownian motions W
fi (t) and W
fj (t) are correlated according to

dW
fi (t)dW
fj (t) = κij (t)dt

where κij (t) is a nonrandom and continuous function taking values in the interval

[−1, 1] . The instantaneous correlation matrix (κij (t)) should be nonnegative semid-

inite for all t ∈ [0, T ] . The distribution of z(t) can be calculated as shown in the

next theorem.

Theorem 3. Let t ∈ (0, T ] be xed. Then the random variable z(t) is m-dimensional
normal distributed with mean 0 and covariance matrix

Σ(t) = (σij (t))

where
ˆ t
(2.4) σij (t) = σi (s, t)σj (s, t)κij (s)ds
0

Proof. We should keep in mind for the reminder of the proof that t is a xed
parameter. Let r ∈ Rm be an arbitrary vector. We show that rz(t) is normal

distributed with mean 0 and variance rΣ(t)r. The variance rΣ(t)r can be equal 0

for r 6= 0. To avoid this case, we consider the process

m
X ˆ u
h(u) = ri σi (s, t)dW
fi (s) + W (u)
i=1 0

where W (u) is an independent Brownian motion and u ∈ [0, T ] . By Theorem 6

(see Appendix) it suces to show that h(t) is normal distributed with mean 0 and

variance rΣ(t)r + t.

First we prove that the process h(u) can be represented as a pure Ito integral

of a nonrandom function with respect to the Brownian motion. We dene the

deterministic function

m X
X m
f (u) = ri rj σi (u, t)σj (u, t)κij (u) + 1
i=1 j=1
5

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for u ∈ [0, T ] . The function f (u) is strictly positive for u > 0, because the covariance

matrix (κij (u)) is nonnegativ semidenite. We rewrite the process h(u) in the

dierential notation
m
X
(2.5) dh(u) = ri σi (u, t)dW
fi (u) + dW (u)
i=1

and consider the process B(u) dened by

1
(2.6) dB(u) = p dh(u)
f (u)

Combining (2.6) with (2.5) we obtain

m
!
1 X
dB(u) = p ri σi (u, t)dWi (u) + dW (u)
f
f (u) i=1
m
X 1 fi (u) + p 1 dW (u)
= p ri σi (u, t)dW
i=1
f (u) f (u)

The process B(u) is a sum of pure Ito integrals of continuous deterministic functions.

Thus the process B(u) is a martingale with continuous paths and B(0) = 0. We

calculate the quadratic variation of B(u) as follows

dB(u)dB(u)
m X
m
X 1 fj (u) + 1 dW (u)dW (u)
= ri σi (u, t)rj σj (u, t)dWfi (u)dW
i=1 j=1
f (u) f (u)
 
m m
1 X X
= ri rj σi (u, t)σj (u, t)κij (u) + 1 du
f (u) i=1 j=1

= du

By Levy's theorem (see Shreve [2004, Th. 4.6.4]) the process B(u) is a Brownian

motion. The process h(u) may be rewritten as

p 1 p
dh(u) = f (u) p dh(u) = f (u)dB(u)
f (u)

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By Shreve [2004, Th. 4.4.9] the random variable h(t) is normally distributed with

expected value zero and variance

ˆ t
f (u)du = rΣ(t)r + t
0

Let s, t ∈ [0, T ] be xed time points with 0 < s < t. Using the previous results

we calculate the joint conditional distribution of the stochastic factors xi (t) and

supplemental variables yi (t) given xi (s) and yi (s). Let m = 2d. We dene the

time-shifted m-dimensional Brownian motion by

W fi+d (u) = Wi (u + s) − Wi (s)

fi (u) = W

for i = 1, . . . , d and u ∈ [0, T − s] . The instantaneous correlation of W

fn (u) and

fl (u) is also
W

κnl (u) = dW
fn (u)dW
fl (u) = dWi (u + s)dWj (u + s) = ρij (u + s)du

where i, j ∈ {1, . . . , d} , n ∈ {i, i + d} and l ∈ {j, j + d} . Thus the instanta-

neous correlation matrix (κnl (u)) is nonnegative semidenite. We consider the

m-dimensional process z(u) dened by

ˆ u+s 
(2.7) zi (u) = xi (u + s) − xi (s) exp ai (v)dv
s

and

(2.8) zi+d (u) = yi (u + s) − yi (s) + xi (s)λi (s, u)

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for u ∈ [0, T − s] . By Lemma 1 we obtain for the leading d components of z (u) the

following exact formula

ˆ u+s 
zi (u) = xi (u + s) − xi (s) exp ai (v)dv
s
ˆ u+s ˆ u+s 
= σi (r) exp ai (v)dv dWi (r)
s r
ˆ u ˆ u+s 
= σi (r + s) exp ai (v)dv dWi (r + s)
0 r+s
ˆ u ˆ u 
(2.9) = σi (r + s) exp ai (v + s)dv dW
fi (r)
0 r

By Theorem 2 we get the following representation

zi+d (u) = yi (u + s) − yi (s) + xi (s)λi (s, u)

ˆ u+s
= σi (r)λi (r, u + s)dWi (r)
s
ˆ u
= σi (r + s)λi (r + s, u + s)dWi (r + s)
0
ˆ u
(2.10) = σi (r + s)λi (r + s, u + s)dW
fi+d (r)
0

for i = 1, . . . , d. The process z(u) fullls the requirements of Theorem 3. Thus z(t−

s) is normal distributed with expected value 0 and variance (2.4). By denition (2.7)

and (2.8) of z(u) we obtain the joint distribution of all xi (t) and yi (t) conditional

on the previous values xi (s) and yi (s).

3. Examples and simulation results

We consider two popular interest rate models which are often mentioned in

the literature and used in the nancial industry particularly due to the analytical

tractability. The Hull-White model and the G2++ model are described in details in

Brigo and Mercurio [2006]. We valuate swaptions by exact Monte Carlo simulation

and compare results with the discrete simulation schema. The swaptions are chosen

for the comparison purpose because its theoretical prices can be calculated for the

Hull-White as well as G2++ model.

8

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 The discrete simulation schema uses exact conditional distribution of the sto-

chastic factors xi (t) given by Lemma 1. However the supplemental processes yi (t)

are calculated by numerical integration

yi (t + δ) ≈ yi (t) + δxi (t + δ)

where δ is suciently small discretization step. The exact simulation schema avoids

any discretization and calculates all factors xi (t) and yi (t) simultaneously condi-

tional on the previous values xi (s) and yi (s) for s < t.

The Hull-White and G2++ models have the stochastic factors of the form

dxi (t) = ai xi (t)dt + σi dWi (t)

with constant mean reversion speed ai and volatility σi . For 0 < s < t we obtain
ˆ t
xi (t) = xi (s) exp (ai (t − s)) + σi exp (ai (t − u)) dWi (u)
s

by Lemma 1 and
ˆ t
xi (s) σi
yi (t) = yi (s) + (exp (ai (t − s)) − 1) + (exp (ai (t − u)) − 1) dWi (u)
ai ai s

by Theorem 2. Taking equations (2.9) and (2.10) into account the process z(u) is

given by
ˆ u
zi (u) = σi exp (ai (u − r)) dW
fi (r)
0

and
ˆ u
σi
zi+d (u) = (exp (ai (u − r)) − 1) dW
fi (r)
ai 0

for i = 1, . . . , d.

Example 4. In case of the Hull-White model there is only one stochastic factor

x1 (t) and d = 1. By Theorem 3 the random variable z(u) is bivariate normal

distributed with expected value 0 and covariance matrix Σ(u) = (σij (u)) , where

σ12
σ11 (u) = (exp (2a1 u) − 1)
2a1
9

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 σ12 2
σ12 (u) = σ21 (u) = (exp (a1 u) − 1)
2a21

σ2
 
2 1 3
σ22 (u) = 21 u− exp (a1 u) + exp (2a1 u) +
a1 a1 2a1 2a1
By denition (2.7) and (2.8) of z(u) the random variable (x1 (t) , y1 (t)) is normal

distributed with the covariance matrix Σ(t − s) and expected value µ(t − s) condi-

tional on (x1 (s) , y1 (s)) , where

µ1 (u) = x1 (s) exp (a1 u)

x1 (s)
µ2 (u) = y1 (s) + (exp (a1 u) − 1)
a1
The simulation results are shown in Table 1 for the at-the-money swaption with

tenor 10 years and maturity 20 years. The Hull-White model parameters are a1 =

−0.1 and σ1 = 0.04.

Example 5. The G2++ model consists of the two stochastic factors x1 (t) and

x2 (t), which are correlated due to

dW1 (t) dW2 (t) = ρdt

with a constant ρ ∈ (−1, 1) . We consider the process z(u) dened by (2.7) and

(2.8), where the instantaneous correlation matrix is given as

 
1 ρ 1 ρ
 
 
 ρ 1 ρ 1 
(κij (u)) = 
 

 1 ρ 1 ρ 
 
 
ρ 1 ρ 1

For the simplicity of notation we set ai+2 = ai and σi+2 = σi for i ∈ {1, 2} . By

Theorem 3 the random variable z(u) is normal distributed with expected value 0

and covariance matrix Σ(u) = (σij (u)) , where

1
β(a, u) = (exp (au) − 1)
a
10

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 σij (u) = σi σj κij β (ai + aj , u)
σn σl
σnl (u) = κnl (β (an + al , u) − β (an , u) − β (al , u) + u)
an al
σi σn
σin (u) = σni (u) = κin (β (ai + an , u) − β (ai , u))
an
for i, j ∈ {1, 2} and n, l ∈ {3, 4} . Thus the random variable (x1 (t) , x2 (t) , y1 (t) , y2 (t))

is multivariate normal distributed conditional on (x1 (s) , x2 (s) , y1 (s) , y2 (s)) with

the covariance matrix Σ (t − s) and expected value µ (t − s) , where

µi (u) = xi (s) exp (ai u)

µi+2 (u) = yi (s) + xi (s)β (ai , u)

for i ∈ {1, 2} . The simulation results of the G2++ model are summarized in Table

2 for the parameters a1 = 0.8, a2 = 0.07, σ1 = 0.02, σ2 = 0.01 and ρ = −0.7.

The simulation results in Table 1 and 2 show some considerable discretization

errors which disappear with increasing number of discretization steps as expected.

However the appropriate discretization yields an additional computational burden

which increases rapidly with the number of discretization steps. In case of the exact

simulation schema the discretization error can be completely avoided. There is also

strong increase in the simulation speed particularly if only few points in time should

be simulated.

Appendix

Theorem 6. Let X1 and X2 be independent random variables. Let X1 be normal

distributed with mean µ1 and variance σ12 . If the sum X1 + X2 is normal distributed
with mean µ1 + µ2 and variance σ12 + σ22 , then X2 is normal distributed with mean
µ2 and variance σ22 .

Proof. We consider the characteristic function fX1 +X2 (s) of X1 + X2 . By Jacod

and Protter [2000, Cor. 14.1.] we have
 
1 2 2
fX1 +X2 (s) = fX1 (s)fX2 (s) = exp iµ1 s − σ1 s fX2 (s) .
2
11

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On the other hand, the characteristic function of X1 + X2 is
 
1 2 2

2
fX1 +X2 (s) = exp is (µ1 + µ2 ) − σ + σ2 s .
2 1

Thus the characteristic function of X2 is

 
1 2 2
fX2 (s) = exp iµ2 s − σ2 s
2

and the statement follows by Jacod and Protter [2000, Th. 14.1.]. 

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1053, 2003.

Darrell Due and Rui Kan. A yield-factor model of interest rates. Mathematical
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Financial Analysts Journal, Nov/Dec:3444, 2001.

Jean Jacod and Philip Protter. Probability essentials. 2-nd Edition. Springer, 2000.
12

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Philip Protter. Stochastic integration and dierential equations. In Stochastic
Modelling and Applied Probability. Springer, 2005.
Steven Shreve. Stochastic Calculus for Finance II : Continuous-Time Models.
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 number of runs (in 100.000)
simulation schema
1 2 5 10
discrete, 1 step a year -0.73 1.22 0.92 1.27
discrete, 5 steps a year -1.58 0.45 0.76 0.45
discrete, 10 steps a year -1.57 -0.06 0.32 0.35
discrete, 20 steps a year 1.00 0.87 0.11 0.27
discrete, 50 steps a year -0.60 -0.52 -0.24 0.25
exact, single step to maturity -0.46 -0.39 -0.02 -0.09
Table 1. Hull White model, relative deviation (%) of the theoret-
ical and Monte Carlo prices of at-the-money swaption with tenor
10 years and maturity 20 years.

number of runs (in 100.000)

simulation schema
1 2 5 10
discrete, 1 step a year 0.45 0.50 0.41 0.20
discrete, 5 steps a year -0.17 -0.12 -0.9 -0.7
discrete, 10 steps a year 0.72 0.19 0.08 0.04
discrete, 20 steps a year 0.26 0.28 0.09 0.03
discrete, 50 steps a year -0.06 0.09 0.06 0.02
exact, single step to maturity -0.01 0.02 -0.03 -0.01
Table 2. G2++ model, relative deviation (%) of the theoretical
and Monte Carlo prices of at-the-money swaption with tenor 10
years and maturity 20 years.

14

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