Monte Carlo Simulation: IEOR E4703 Fall 2004

c 2004 by Martin Haugh

°

Generating Random Variables and Stochastic

Processes

1 Generating U(0,1) Random Variables

The ability to generate U (0, 1) random variables is of fundamental importance since they are usually the
building block for generating other random variables. We will look at:
• Properties that a random number generator should possess
• Linear Congruential Generators
• Using Matlab to generate U (0, 1) variates

Some History

• Earliest methods were manual

– throwing dice, dealing cards, drawing balls from an urn
• Mechanized devices in early 1900’s
• Later, methods based on electric circuits
• Many other schemes based on phone books, π etc.
• Advent of computing led to interest in numerical and arithmetic methods
– such methods generate numbers sequentially and are easily programmed
– the most commonly used methods today

Desirable Properties of a U(0,1) Generator

• Numbers should appear to be ∼ U (0, 1) and independent
• Generator should be fast and not require too much storage
• Should be able to reproduce a given set of numbers
– important for comparison purposes

1.1 Linear Congruential Generators

A linear congruential generator has the property that numbers are generated according to

Zi = (aZi−1 + c) mod m

where m, a, c and Z0 are non-negative integers. We say that m is the modulus and that Z0 is the seed. The
sequence that we obtain clearly satisfies 0 ≤ Zi < m . In order to generate pseudo-random numbers,
U1 , . . . , Un , . . ., we set Ui = Zi /m. Note that Ui ∈ (0, 1) for each i.
We now act as though the Ui ’s constitute an independent sequence of U (0, 1) random variables.
Generating Random Variables and Stochastic Processes 2

Example 1 (Law and Kelton)

Z0 = 1, Zi = (11 Zi−1 ) mod 16
Now iterate to determine the Zi ’s

Z0 = 1
Z1 = (11) mod 16 = 11
Z2 = (121) mod 16 = 9
Z3 = (99) mod 16 = 3
Z4 = (33) mod 16 = 1
Z5 = ···
Z6 = ···

What is wrong with this?

Possible Objections
1. The Zi ’s are notrandom?
2. They can only take on a finite number of values
3. The period of the generator can be very poor: see previous example

Responses

1. As long as the Zi ’s appear to be random, it’s ok

2. Choose m very large
3. See theorem below

How to Guarantee a Full Period

Theorem 1 The linear congruential generator has full period if and only if the following 3 conditions hold:
1. If 4 divides m, then 4 divides a − 1
2. The only positive integer that exactly divides both m and c is 1, i.e., m and c are relatively prime
3. If q is a prime number that divides m, then it divides a − 1

Example 2 (Law and Kelton)

Z0 = 1, Zi = (13Zi−1 + 13) mod 16
Now iterate to determine the Zi ’s

Z0 = 1
Z1 = (26) mod 16 = 10
Z2 = (143) mod 16 = 15
Z3 = (248) mod 16 = 0
Z4 = (13) mod 16 = 13
Z5 = ···

Check to see that this LCG has full period:

Generating Random Variables and Stochastic Processes 3

• Are the conditions of the theorem satisfied?

• Does it matter what integer we use for Z0 ?

Testing Random Number Generators

• Some simple checks are to examine mean and variance

• Tests for U (0, 1) distribution
– Kolmogorov Smirnov test
– χ2 test
• Tests for independence
– serial tests
– runs tests
– autocorrelation tests

Constructing and testing good random number generators is very important! However, we will not study these
issues in this course. Instead, we will assume that we have a good random number generator available to us and
we will use it as a black box. See Law and Kelton, Chapter 7, for an excellent treatment and further details.

Generating U (0, 1) Variates in Matlab

> x = rand(10,1);
% generate a vector of 10 U(0,1) random variables

> m = mean(x);
% compute the mean of x

> var = std(x)^2

% compute the variance of x

2 Monte Carlo Integration

2.1 One-Dimensional Monte Carlo Integration
Suppose we want to compute Z 1
θ= g(x) dx.
0
If we cannot compute θ analytically, then we could use numerical methods. However, we can also use simulation
and this can be especially useful for high-dimensional integrals. The key observation is to note that

θ = E[g(U )]

where U ∼ U (0, 1). How do we use this observation?

1. Generate U1 , U2 , . . . Un ∼ U (0, 1) and independent

2. Estimate θ with
g(U1 ) + . . . + g(Un )
θbn :=
n
Generating Random Variables and Stochastic Processes 4

There are two reasons why θbn is a good estimator

1. It is unbiased, i.e., E[θbn ] = θ and

2. It is consistent, i.e., θbn → θ as n → ∞ with probability 1

- follows from the Strong Law of Large Numbers

Proof of Consistency

• U1 , U2 , . . . Un are IID U (0, 1)

• So g(U1 ), g(U2 ), . . . , g(Un ) are IID with mean θ
• Then by the Strong Law of Large Numbers
g(U1 ) + . . . + g(Un )
lim →θ with probability 1
n→∞ n

Example 3 (Computing a 1-Dimensional Integral)

R1
Suppose we wish to estimate 0 x3 dx using simulation:
• Know the exact answer is 1/4
• Using simulation
– generate n U (0, 1) independent variables
– cube them
– take the average

Sample Matlab Code

> n=100;
> x = rand(n,1);
> g = x.^3;
> estimate = mean(g)
% or more economically
> estimate = 2*mean(rand(100,1).^3)

Example 4
R3
Suppose we wish to estimate θ = 1
(x2 + x) dx using simulation:
• Know the exact answer is 12.67
• Using simulation
– note that Z 3
x2 + x
θ = 2 dx = 2E[X 2 + X]
1 2
where X ∼ U (1, 3)
– so generate n U (0, 1) independent variables
Generating Random Variables and Stochastic Processes 5

– convert them to U (1, 3) variables; how?

– estimate θ
Sample Matlab Code
> n=100000;
> x=2*rand(n,1)+1;
> y=x.^2 + x;
> estimate = mean(y)
R1
We could also have used a change of variables to convert the integral to an integral of the form 0
. . . dx and
then estimated θ as in Example 3.

2.2 Multi-Dimensional Monte Carlo Integration

Suppose now that we wish to approximate
Z 1 Z 1
θ= g(x1 , x2 ) dx1 dx2 .
0 0

Then we can write

θ = E[g(U1 , U2 )]
where U1 , U2 are IID U (0, 1) random variables.
Note that the joint PDF satisfies fu1 ,u2 (u1 , u2 ) = fu1 (u1 )fu2 (u2 ) = 1 on (0, 1)2 .
As before we can estimate θ using simulation:
• Generate 2n independent U (0, 1) variables
• Compute g(U1i , U2i ) for i = 1, . . . , n
• Estimate θ with
g(U11 , U21 ) + . . . + g(U1n , U2n )
θbn =
n
As before, the Strong Law of Large Numbers justifies this approach.

Example 5 (Computing a Multi-Dimensional Integral)

We can estimate Z Z
1 1
θ := (4x2 y + y 2 ) dxdy.
0 0
using simulation though of course the true value of θ is easily calculated to be 1.

Sample Matlab Code

> x=rand(1,n);
> y=rand(1,n);
> g=4*(x.^2).*y + y.^2;
> ans=mean(g)

We can also apply Monte Carlo integration to more general problems. For example, if we want to estimate
Z Z
θ= g(x, y)f (x, y) dx dy
A
Generating Random Variables and Stochastic Processes 6

where f (x, y) is a density function on A, then we observe that

θ = E[g(X, Y )]

where X, Y have joint density f (x, y). To estimate θ using simulation we

• Generate n random vectors (X, Y ) with joint density f (x, y)
• Estimate θ with
g(X1 , Y1 ) + . . . + g(Xn , Yn )
θbn =
n

In the next part of this lecture, we will begin learning how to generate random variables that are not uniformly
distributed.

3 Generating Univariate Random Variables

We will study a number of methods for generating univariate random variables. The three principal methods are
the inverse transform method, the composition method and the acceptance-rejection method. All of these
methods rely on having a U (0, 1) random number generator available, and for the duration of the course we will
assume this to be the case.

3.1 The Inverse Transform Method for Discrete Random Variables

Suppose X is a discrete random variable with probability mass function (PMF)

 x1 , wp p1
X= x2 , wp p2

x3 , wp p3

where p1 + p2 + p3 = 1. We would like to generate a value of X and we can do this by using our U (0, 1)
generator:
1. Generate U
2. Set 
 x1 , if 0 ≤ U ≤ p1
X= x2 , if p1 < U ≤ p1 + p2

x3 , if p1 + p2 < U ≤ 1

We can check that this is correct as follows.

P(X = x1 ) = P(0 ≤ U ≤ p1 ) = p1

since U is U (0, 1). The same is true for P(X = x2 ) and P(X = x3 ).

More generally, suppose X can take on n distinct values, x1 < x2 < . . . < xn , with

P(X = xi ) = pi for i = 1, . . . , n.

Then to generate a sample value of X we

1. Generate U
Pj−1 Pj
2. Set X = xj if i=1 pi < U ≤ i=1 pi

That is, set X = xj if F(xj−1 ) < U ≤ F(xj )

Generating Random Variables and Stochastic Processes 7

If n is large, then we might want to search for xj more efficiently.

Example 6 (Generating a Geometric Random Variable)

Suppose X is geometric with parameter p so that P(X = n) = (1 − p)n−1 p. Then we can generate X as
follows.
1. Generate U
Pj−1 Pj
2. Set X = j if i=1 (1 − p)i−1 p < U ≤ i=1 (1 − p)i−1 p

That is, set X = j if 1 − (1 − p)j−1 < U ≤ 1 − (1 − p)j

³ ´
log(U )
In particular, we set X = Int log(1−p) + 1 where Int(y) denotes the integer part of y.

You should convince yourself that this is correct! How does this compare to the coin-tossing method for
generating X?

Example 7 (Generating a Poisson Random Variable)

Suppose that X is Poisson(λ) so that P(X = n) = exp(−λ) λn /n! . We can generate X as follows.
1. Generate U
2. Set
X = j if F(j − 1) < U ≤ F(j)

Some questions arise:

• How do we find j? We could use the following algorithm.

set j = 0, p = e−λ , F = p
while U > F
set p = λp/(j + 1), F = F + p, j = j + 1
set X = j

• How much work does this take

• What if λ is large?
– can we find j more efficiently?
– yes: check if j is close to λ first.
– why might this be useful?
– how much work does this take? (See Ross)
Generating Random Variables and Stochastic Processes 8

3.2 The Inverse Transform Method for Continuous Random Variables

Suppose now that X is a continuous random variable and we want to generate a value of X. Recall that when
X was discrete, we could generate a value as follows:

• Generate U
• Then set X = xj if F(xj−1 ) < U ≤ F(xj )

This suggests that when X is continuous, we might generate X as follows.

Inverse Transform Algorithm for Continuous Random Variables:

1. Generate U
2. Set X = x if Fx (x) = U , i.e., set X = F−1
x (U )

We need to prove that this actually works!

Proof: We have
−1
P(X ≤ x) = P(Fx (U ) ≤ x)

= P(U ≤ Fx (x))

= Fx (x)

This assumes F−1 −1

x exists but even when Fx does not exist we’re still ok. All we have to do is

1. Generate U
2. Set
X = min{x : Fx (x) ≥ U }

This works for discrete and continuous random variables or mixtures of the two.

Example 8 (Generating an Exponential Random Variable)

Problem: Generate X ∼ Exp(λ)

Solution: Fx (X) = 1 − e−λx

Compute Fx−1 (u): u = 1 − e−λx so x = − λ1 log(1 − u)

Can use x = − log(u)/λ . Why?

Example 9 (Generating a Gamma(n,λ) Random Variable)

Problem: Generate X ∼ Gamma(n, λ)
Generating Random Variables and Stochastic Processes 9

Solution: Suppose n a positive integer

Let Xi be IID ∼ exp(λ) for i = 1, . . . , n

So if Y := X1 + . . . + Xn then Y ∼ Gamma(n, λ) !

So how can we generate a sample value of Y ?

If n not an integer, need another method to generate Y

Example 10 (Order Statistics)

Order statistics are very important and have many applications.
• Suppose X has CDF Fx
• Let X1 , . . . , Xn be IID ∼ X
• Let X(1) , . . . , X(n) be the ordered sample
– so that X(1) ≤ X(2) ≤ . . . ≤ X(n)
– say X(i) is the ith ordered statistic

Question: How do we generate a sample of X(i) ?

Method 1:
• Generate U1 , . . . , Un
• Compute X1 = F−1 −1
X (U1 ), . . . , FX (Un )

• Order the Xi ’s and take the ith smallest

• How much work does this take?

Question: Can we do better?

Method 2:
• Sure, use the monotonicity of F !

Question: Can we do even better?

Method 3:
• Say Z ∼ beta(a, b) on (0, 1) if

f (z) = cz a−1 (1 − z)a−1 for 0 ≤ z ≤ 1

where c is a constant
• How can we use this?
Question: Can we do even better?
Generating Random Variables and Stochastic Processes 10

Advantages of Inverse Transform Method

• Monotonicity
– we have already seen how this can be useful
• Variance reduction techniques
– inducing correlation
– ‘1 to 1’, i.e. one U (0, 1) variable produces one X variable

Disadvantages of Inverse Transform Method

• F−1
x may not always be computable

– e.g. if X ∼ N(0, 1) then Z µ ¶

x
1 −z 2
Fx (x) = √ exp dz
−∞ 2π 2
– here we cannot even express Fx in closed form

• Even if Fx available in closed form, may not be possible to find F−1

x in closed form.

– e.g. Fx (x) = x5 (1 + x)3 /8 for 0 ≤ x ≤ 1

One possible solution to these problems is to find F−1

x numerically.

3.3 The Composition Approach

Another method for generating random variables is the composition approach. Suppose again that X has CDF
Fx and we wish to simulate a value of X.
• Can often write
∞
X
Fx (x) = pj Fj (x)
j=1
P
where the Fj ’s are also CDFs, pj ≥ 0 for all j, and pj = 1

• Equivalently, if the densities exist then we can write

∞
X
fx (x) = pj fj (x)
j=1

• Such a representation often occurs very naturally

– e.g. X ∼ Hyperexponential(λ1 , α1 , . . . , λn , αn )
n
X
fx (x) = αi λi e−λi x
j=1
Pn
where λi , αi ≥ 0, and i αi = 1. Here αi = 0 for i > n

Suppose now that it’s difficult to simulate X directly using the inverse transform method. Then we could use
the composition method instead.
Generating Random Variables and Stochastic Processes 11

Composition Algorithm:

1. Generate I that is distributed on the non-negative integers so that

P(I = j) = pj

How do we do this?
2. If I = j, then simulate Yj from Fj

3. Set X = Yj

We claim that X has the desired distribution!

Proof:
∞
X
P(X ≤ x) = P(X ≤ x|I = j) P(I = j)
j=1
X∞
= P(Yj ≤ x) P(I = j)
j=1
X∞
= Fj (x)pj
j=1
= Fx (x)

The proof actually suggests that the composition approach might arise naturally from ‘sequential’ type
experiments. Consider the following example.

Example 11 (A Sequential Experiment)

Suppose we roll a dice and let Y ∈ {1, 2, 3, 4, 5, 6} be the outcome. If If Y = i then we generate Zi from the
distribution Fi and set X = Zi .
What is the distribution of X? How do we simulate a value of X?

Example 12 (The Hyperexponential Distribution)

Let X ∼ Hyperexponential(λ1 , α1 , λ2 , α2 ) so that

fx (x) = α1 λ1 e−λ1 x + α2 λ2 e−λ2 x .

In our earlier notation we have

α1 = p1
α2 = p2
f1 (x) = λ1 e−λ1 x
f2 (x) = λ2 e−λ2 x

and the following algorithm will then generate a sample of X.

Generating Random Variables and Stochastic Processes 12

generate U1
if U1 ≤ p1 then
set i = 1
else set i = 2
generate U2
/∗ Now generate X from Exp(λi ) ∗/
set
1
X = − log(U2 )
λi

Question: How would you simulate a value of X if Fx (x) = (x + x3 + x5 )/3 ?

When the decomposition

∞
X
Fx = pj Fj (x)
j=1

is not obvious, we can create an artificial decomposition by splitting.

Example 13 (Splitting)
Suppose
1 6
fx (x) = 1[−1,0] (x) + 1[0,2] (x).
5 15
How do we simulate a value of X using vertical splitting?
How would horizontal splitting work?

3.4 The Acceptance-Rejection Algorithm

Let X be a random variable with density, f (·), and CDF, Fx (·). Suppose it’s hard to simulate a value of X
directly using either the inverse transform or composition algorithm. We might then wish to use the
acceptance-rejection algorithm.
Let Y be another random variable with density g(·) and suppose that it is easy to simulate a value of Y . If there
exists a constant a such that
f (x)
≤ a for all x
g(x)
then we can simulate a value of X as follows.

The Acceptance-Rejection Algorithm

generate Y with PDF g(·)

generate U
f (Y )
while U > ag(Y )
generate Y
generate U
set X = Y
Generating Random Variables and Stochastic Processes 13

Question: Why must a ≥ 1?

We must now check that this algorithm does indeed work. We define B to be the event that Y has been
accepted in a loop, i.e., U ≤ f (Y )/ag(Y ). We need to show that P(X ≤ x) = Fx (x)

Proof: First observe

P(X ≤ x) = P(Y ≤ x|B)

P ((Y ≤ x) ∩ B)
= . (1)
P(B)
Then the denominator in (1) is given by
µ ¶
f (Y )
P(B) = P U≤
ag(Y )
1
=
a
while the numerator in (1) satisfies
Z ∞
P ((Y ≤ x) ∩ B) = P ((Y ≤ x) ∩ B | Y = y) g(y) dy
−∞
Z µ ∞ µ ¶ ¯ ¶
f (Y ) ¯
= P (Y ≤ x) ∩ U ≤ ¯ Y = y g(y) dy
−∞ ag(Y )
Z x µ ¶
f (y)
= P U≤ g(y) dy (why?)
−∞ ag(y)
Fx (x)
=
a
Therefore P(X ≤ x) = Fx (x), as required.

Example 14 (Generating a Beta(a, b) Random Variable)

Recall that X has a Beta(a, b) distribution if f (x) = cxa−1 (1 − x)b−1 for 0 ≤ x ≤ 1.
Suppose now that we wish to simulate from the Beta(4, 3) so that

f (x) = 60x3 (1 − x)2 for 0 ≤ x ≤ 1.

We could, for example, integrate f (·) to find F(·), and then try to use the inverse transform approach. However,
it is hard to find F−1 (·). Instead, let’s use the acceptance-rejection algorithm:

1. First choose g(y): let’s take g(y) = 1 for y ∈ [0, 1], i.e., Y ∼ U (0, 1)
2. Then find a. Recall that we must have
f (x)
≤ a for all x,
g(x)
which implies
60x3 (1 − x)2 ≤ a for all x ∈ [0, 1].
So take a = 3. It is easy to check that this value works. We then have the following algorithm.
Generating Random Variables and Stochastic Processes 14

Algorithm

generate Y ∼ U (0, 1)
generate U ∼ U (0, 1)
while U > 20Y 3 (1 − Y )2
generate Y
generate U
set X = Y

Efficiency of the Acceptance-Rejection Algorithm

Let N be the number of loops in the A-R algorithm until acceptance, and as before, let B be the event that Y
f (Y )
has been accepted in a loop, i.e. U ≤ ag(Y ) . We saw earlier that P(B) = 1/a.

Questions:
1: What is the distribution of N ?
2: What is E[N ]?

How Do We Choose a ?
E[N ] = a, so clearly we would like a to be as small as possible. Usually, this is just a matter of calculus.

Example 15 (Generating a Beta(a, b) Random Variable continued)

Recall the Beta(4, 3) example with PDF f (x) = 60x3 (1 − x)2 for x ∈ [0, 1].
We chose g(y) = 1 for y ∈ [0, 1] so that Y ∼ U (0, 1). The constant a had to satisfy

f (x)
≤a for all x ∈ [0, 1]
g(x)

and we chose a = 3.
We can do better by choosing
f (x)
a = max ≈ 2.073.
x∈[0,1] g(x)

How Do We Choose g(·) ?

• Would like to choose g(·) to minimize the computational load

– can do this by taking g(·) ‘close’ to f (·)

– then a close to 1 and fewer iterations required
• But there is a tradeoff
– if g(·) ‘close’ to f (·) then will probably also be hard to simulate from g(·)
• So often need to find a balance between having a ‘nice’ g(·) and a small a
Generating Random Variables and Stochastic Processes 15

3.5 Acceptance-Rejection Algorithm for Discrete Random Variables

So far, we have expressed the A-R algorithm in terms of PDF’s, thereby implicitly assuming that we are
generating continuous random variables. However, the A-R algorithm also works for discrete random variables
where we simply replace PDF’s with PMF’s.
So suppose we wish to simulate a discrete random variable, X, with PMF, pi = P(X = xi ). If we do not wish
to use the discrete inverse transform method for example, then we can use the following version of the A-R
algorithm. We assume that we can generate Y with PMF, qi = P(Y = yi ), and that a satisfies pi /qi ≤ a for all
i.

The Acceptance-Rejection Algorithm for Discrete Random Variables

generate Y with PMF qi

generate U
pY
while U > aq Y

generate Y
generate U
set X = Y

Generally, we would use this A-R algorithm when we can simulate Y efficiently.

Exercise 1 (Ross Q4.13)

Suppose Y ∼ Bin(n, p) and that we want to generate X where

P(X = r) = P(Y = r|Y ≥ k)

for some fixed k ≤ n. Assume α = P(Y ≥ k) has been computed.

1. Give the inverse transform method for generating X

2. Give another method for generating X
3. For what values of α, small or large, would the algorithm in (2) be inefficient?

Example 16 (Generating from a Uniform Distribution over a 2-D Region)

Suppose (X, Y ) is uniformly distributed over a 2-dimensional area, A. How would you simulate a sample of
(X, Y )?
• Note first that if X ∼ U (−1, 1), Y ∼ U (−1, 1) and X and Y are independent then (X, Y ) is uniformly
distributed over
A := {(x, y) : −1 ≤ x ≤ 1, −1 ≤ y ≤ 1}
– how would you show this?
• So we can simulate a sample of (X, Y ) when A is a square. How?
• Suppose now A is a circle of radius 1 centered at the origin
– then how do we simulate a sample of (X, Y )?
Generating Random Variables and Stochastic Processes 16

4 Other Methods for Generating Univariate Random Variables

Besides the inverse transform, composition and acceptance-rejection algorithms, there are a number of other
important methods for generating random variables. We begin with the convolution method.

4.1 The Convolution Method

Suppose X ∼ Y1 + Y2 + . . . + Yn where the Yi ’s are IID with CDF Fy (·). Suppose also that it’s easy to
generate the Yi ’s. Then it is straightforward to generate a value of X:
1. Generate Ye1 , . . . , Yen that have CDF Fy

2. Set X = Ye1 + . . . + Yen

We briefly mentioned this earlier in Example 9 when we described how to generate a Gamma(λ, n) random
variable. The convolution method is not always the most efficient method. Why?

4.2 Methods Using Special Properties

Suppose we want to simulate a value of random variable X, and we know that

X ∼ g(Y1 , . . . , Yn )

for some random variables Yi and some function g(·). (Note the Yi ’s need not necessarily be IID.) If we know
how to generate each of the Yi ’s then we can generate X as follows:

1. Generate Ye1 , . . . , Yen

2. Set X = g(Ye1 , . . . , Yen )

Example 17 (Convolution)
The convolution method is a special case where g(Y1 , . . . , Yn ) = Y1 + . . . + Yn .

Example 18 (Generating Lognormal Random Variables)

Suppose X ∼ N(µ, σ 2 ). Then Y := exp(X) has a lognormal distribution, i.e., Y ∼ LN(µ, σ 2 ). (Note E[Y ] 6= µ
and Var(Y ) 6= σ 2 .) How do we generate a log-normal random variable?

Example 19 (Generating χ2 Random Variables)

Suppose X ∼ N(0, 1). Then Y := X 2 has a a chi-square distribution with 1 degree of freedom, i.e., Y ∼ χ21 .
Question: How would you generate a χ21 random variable?
Suppose now that Xi ∼ χ21 for i = 1, . . . , n. Then Y := X1 + . . . + Xn has a chi-square distribution with n
degree of freedom, i.e., Y ∼ χ2n .
Question: How would you generate a χ2n random variable?
Generating Random Variables and Stochastic Processes 17

Example 20 (Generating tn Random Variables)

Suppose X ∼ N(0, 1) and Y ∼ χ2n with X and Y independent. Then

X
Z := q
Y
n

has a a t distribution with n degrees of freedom , i.e., Z ∼ tn .

Question: How would you generate a tn random variable?

Example 21 (Generating Fm,n Random Variables)

Suppose X ∼ χ2m and Y ∼ χ2n with X and Y independent. Then
¡X ¢
Z := ¡ m
Y
¢
n

has an F distribution with m and n degrees of freedom, i.e., Z ∼ Fm,n .

Question: How would you generate a Fm,n random variable?

Note: The proof of the statements in these examples can be found in many probability or statistics textbooks

5 Generating Normal Random Variables

We have not yet seen how to generate normal random variables though they are of course very important in
practice. Though important in their own right, we need to be able to generate normal random variables so that
we can then generate lognormal random variables. These variables are very important for financial engineering
applications.

• Note that if Z ∼ N(0, 1) then

X := µ + σZ ∼ N(µ, σ 2 )

– so we need only worry about generating N(0, 1) random variables

– why?
• One possible generation method is the inverse transform method
– but we would have to use numerical methods since we cannot find Fz−1 (·) = Φ−1 (·) in closed form
– so not very efficient
• Will therefore look at the following methods for generating N(0, 1) random variables
1. Box-Muller method
2. Polar method
3. Rational approximations
• There are many other methods, e.g., A-R algorithm
Generating Random Variables and Stochastic Processes 18

5.1 The Box Muller Algorithm

The Box-Muller algorithm uses two IID U (0, 1) random variables to produce two IID N(0, 1) random variables.
It works as follows:

The Box-Muller Algorithm for Generating Two IID N(0, 1) Random Variables

generate U1 and U2 IID U (0, 1)

set
p p
X = −2 log(U1 ) cos(2πU2 ) and Y = −2 log(U1 ) sin(2πU2 )

We now show that this algorithm does indeed produce two IID N(0, 1) random variables, X and Y .
Proof: We need to show that
µ 2¶ µ 2¶
1 x 1 y
f (x, y) = √ exp − √ exp −
2π 2 2π 2
First, make a change of variables:
p
R := X2 + Y 2
µ ¶
Y
θ := tan−1
X

so R and θ are polar coordinates of (X, Y ).

To transform back, note X = R cos(θ) and Y = R sin(θ). Note also that
p
R = −2 log(U1 )
θ = 2πU2

Since U1 and U2 are IID, R and θ are independent. Clearly θ ∼ U (0, 2π) so fθ (θ) = 1/2π for 0 ≤ θ ≤ 2π.
2
It is also easy to see that fR (r) = re−r /2
, so
1 −r2 /2
fR,θ (r, θ) = re .
2π
This implies

P(X ≤ x1 , Y ≤ y1 ) = P(R cos(θ) ≤ x1 , R sin(θ) ≤ y1 )

Z Z
1 −r2 /2
= re dr dθ
A 2π
where A = {(r, θ) : r cos(θ) ≤ x, r sin(θ) ≤ y}.
Now transform back to (x, y) coordinates:

x = r cos(θ) and y = r sin(θ)

and note that dxdy = rdrdθ, i.e., the Jacobian of the transformation is r.
We then have Z x1 Z y1 µ ¶
1 (x2 + y 2 )
P(X ≤ x1 , Y ≤ y1 ) = exp − dxdy
2π −∞ −∞ 2
Generating Random Variables and Stochastic Processes 19

Z x1 Z y1
1 1
=√ exp(−x2 /2) dx √ exp(−y 2 /2) dy
2π −∞ 2π −∞

as required.

5.2 The Polar Method

One disadvantage of the Box-Muller method is that computing sines and cosines is inefficient. We can get
around this problem using the polar method.

The Polar Algorithm for Generating Two IID N(0, 1) Random Variables

generate U1 and U2 IID U (0, 1)

set V1 = 2U1 − 1, V2 = 2U2 − 1 and S = V12 + V22
while S > 1
generate U1 and U2 IID U (0, 1)
set V1 = 2U1 − 1, V2 = 2U2 − 1 and S = V12 + V22
set r r
−2 log(S) −2 log(S)
X= V1 and Y = V2
S S

Can you see why this algorithm1 works?

5.3 Rational Approximations

Let X ∼ N(0, 1) and recall that Φ(x) = P(X ≤ x) is the CDF of X. If U ∼ U (0, 1), then the inverse transform
method seeks xu such that
Φ(xu ) = U i.e. xu = Φ−1 (U ).
Finding Φ−1 in closed form is not possible but instead, we can use rational approximations. These are very
accurate and efficient methods for estimating xu .

Example 22 (Rational Approximations)

For 0.5 ≤ u ≤ 1
a0 + a1 t
xu ≈ t −
1 + b1 t + b2 t2
p
where a0 , a1 , b1 and b2 are constants, and t = −2 log(1 − u). The error is bounded in this case by .003. Even
more accurate approximations are available, and since they are very fast, many packages (including Matlab) use
them for generating normal random variables.

1 See Ross for further details.

Generating Random Variables and Stochastic Processes 20

6 Simulating Poisson Processes

Recall that a Poisson process, N (t), with intensity λ is such that
(λt)r e−λt
P (N (t) = r) = .
r!
− the numbers of arrivals in non-overlapping intervals are independent
− and the distribution of the number of arrivals in an interval only depends on the length of the interval
It is good for modelling many phenomena including the emission of particles from a radioactive source, market
crashes, and the arrivals of customers to a queue.
The ith inter-arrival time, Xi , is defined to be the interval between the (i − 1)th and ith arrivals of the Poisson
process, and it is easy to see that the Xi ’s are IID ∼ Exp(λ).
In particular, this means we can simulate a Poisson process with intensity λ by simply generating the
inter-arrival times, Xi , where Xi ∼ Exp(λ). We have the following algorithm for simulating the first T time
units of a Poisson process:

Simulating T Time Units of a Poisson Process

set t = 0, I = 0
generate U
set t = t − log(U )/λ
while t < T
set I = I + 1, S(I) = t
generate U
set t = t − log(U )/λ

6.1 The Non-Homogeneous Poisson Process

A non-homogeneous Poisson process, N (t), is obtained by relaxing the assumption that the intensity, λ, is
constant. Instead we take it to be a deterministic function of time, λ(t). The non-homogeneous Poisson process
can often be very important in practice. Consider, for example:
− a person who is measuring particle emissions from a radioactive source while moving closer to the source
− the occurrence of a market crash or a company bankruptcy as economic variables change
More formally, if λ(t) ≥ 0 is the intensity of the process at time t, then we say that N (t) is a non-homogeneous
Poisson process with intensity λ(t). Define the function m(t) by
Z t
m(t) := λ(s) ds.
0

Then it can be shown that N (t + s) − N (t) is a Poisson random variable with parameter m(t + s) − m(t), i.e.,
exp (−mt,s ) (mt,s )r
P (N (t + s) − N (t) = r) =
r!
where mt,s := m(t + s) − m(t).
Generating Random Variables and Stochastic Processes 21

Simulating a Non-Homogeneous Poisson Process

Before we describe the thinning algorithm for simulating a non-homogeneous Poisson process, we first need the
following2 proposition.

Proposition 2 Let N (t) be a Poisson process with constant intensity λ. Suppose that an arrival that occurs
at time t is counted with probability p(t), independently of what has happened beforehand. Then the process of
counted arrivals is a non-homogeneous Poisson process with intensity λ(t) = λp(t).

Suppose now N (t) is a non-homogeneous Poisson process with intensity λ(t) and that there exists a λ such that
λ(t) ≤ λ for all t ≤ T . Then we can use the following algorithm, based on Proposition 2, to simulate N (t).

The Thinning Algorithm for Simulating T Time Units of a NHPP

set t = 0, I = 0
generate U1
set t = t − log(U1 )/λ
while t < T
generate U2
if U2 ≤ λ(t)/λ then
set I = I + 1, S(I) = t
generate U1
set t = t − log(U1 )/λ

Questions
1) Can you give a more efficient version of the algorithm when there exists λ > 0 such that min0≤t≤T λ(t) ≥ λ?

2) Can you think of another algorithm for simulating a non-homogeneous Poisson process that is not based on
thinning?

6.2 Credit Derivatives Models

Many credit derivatives models use Cox processes to model company defaults. A Cox process, C(t), is similar to
a non-homogeneous Poisson process except that the intensity function, λ(t), is itself a stochastic process.
However, conditional upon knowing λ(t) for all t ∈ [0, T ], C(t) becomes a non-homogeneous Poisson process. In
credit derivatives models, bankruptcy of a company is often modelled as occurring on the first arrival in the Cox
process where the intensity at time t, λ(t), generally depends on the level of other variables in the economy.
Such variables might include, for example, interest rates, credit ratings and stock prices, all of which are
themselves random.
An understanding of and ability to simulate non-homogeneous Poisson processes is clearly necessary for
analyzing such credit derivatives models.

2A proof may be found in Ross, for example.

Generating Random Variables and Stochastic Processes 22

7 Simulating Geometric Brownian Motions

Definition 1 We say that a stochastic process, {Xt : t ≥ 0}, is a Brownian motion with parameters (µ, σ) if
1. For 0 < t1 < t2 < . . . < tn−1 < tn

(Xt2 − Xt1 ), (Xt3 − Xt2 ), . . . , (Xtn − Xtn−1 )

are mutually independent. (This is the independent increments property.)

2. For s > 0, Xt+s − Xt ∼ N(µs, σ 2 s) and

3. Xt is a continuous function of t.

Notation
• We say that X is a B(µ, σ) Brownian motion
– µ is called the drift
– σ is called the volatility
• When µ = 0 and σ = 1 we have a standard Brownian motion (SBM)

– we will use Bt to denote an SBM

– always assume B0 = 0
• Note that if X ∼ B(µ, σ) and X0 = x then we can write

Xt = x + µt + σBt

where B is an SBM. We will usually write a B(µ, σ 2 ) Brownian motion in this way.

Remark 1 Bachelier (1900) and Einstein (1905) were the first to explore Brownian motion from a
mathematical viewpoint whereas Wiener (1920’s) was the first to show that it actually exists as a well-defined
mathematical entity.

Questions
1) What is E[Bt+s Bs ]?
2) What is E[Xt+s Xs ] where X ∼ B(µ, σ)?
3) Let B be an SBM and let Zt := |Bt |. What is the CDF of Zt for t fixed?

7.1 Simulating a Standard Brownian Motion

It is not possible to simulate an entire sample path of Brownian motion between 0 and T as this would require
an infinite number of random variables. This is not always a problem, however, since we often only wish to
simulate the value of Brownian motion at certain fixed points in time. For example, we may wish to simulate
Bti for t1 < t2 < . . . < tn , as opposed to simulating Bt for every t ∈ [0, T ].
Sometimes, however, the quantity of interest, θ, that we are trying to estimate does indeed depend on the entire
sample path of Bt in [0, T ]. In this case, we can still estimate θ by again simulating Bti for t1 < t2 < . . . < tn
but where we now choose n to be very large. We might, for example, choose n so that |ti+1 − ti | < ² for all i,
where ² > 0 is very small. By choosing ² to be sufficiently small, we hope to minimize the numerical error (as
Generating Random Variables and Stochastic Processes 23

opposed to the statistical error), in estimating θ. We will return to this topic at the end of the course when we
learn how to simulate stochastic differential equations.
In either case, we need to be able to simulate Bti for t1 < t2 < . . . < tn and for a fixed n. We will now see how
to do this. The first observation we make is that

(Bt2 − Bt1 ), (Bt3 − Bt2 ), . . . , (Btn − Btn−1 )

are mutually independent, and for s > 0, Bt+s − Bt ∼ N(0, s).

The idea then is as follows: we begin with t0 = 0 and Bt0 = 0. We then generate Bt1 which we can do since
Bt1 ∼ N(0, t1 ). We now generate Bt2 by first observing that Bt2 = Bt1 + (Bt2 − Bt1 ). Then since (Bt2 − Bt1 )
is independent of Bt1 , we can generate Bt2 by generating an N(0, t2 − t1 ) random variable and simply adding it
to Bt1 . More generally, if we have already generated Bti then we can generate Bti+1 by generating an
N(0, ti+1 − ti ) random variable and adding it to Bti . We have the following algorithm.

Simulating a Standard Brownian Motion

set t0 = 0, Bt0 = 0
for i = 1 to n
generate X ∼ N(0, ti − ti−1 ))
set Bti = Bti−1 + X

Remark 2 When we generate (Bt1 , Bt2 , . . . , Btn ) we are actually generating a random vector that does not
consist of IID random variables. In fact the method that we use to simulate (Bt1 , Bt2 , . . . , Btn ) is one of the
most common methods for generating correlated random variables and stochastic processes. We will return to
this later.

Remark 3 It is very important that when you generate Bti+1 , you do so conditional on the value of Bti . If you
generate Bti and Bti+1 independently of one another then you are effectively simulating from different sample
paths of the Brownian motion. This is not correct!

Simulating a B(µ, σ) Brownian Motion

Suppose now that we want to simulate a B(µ, σ) BM, X, at the times t1 , t2 , . . . , tn−1 , tn . Then all we have to
do is simulate an SBM, (Bt1 , Bt2 , . . . , Btn ), and use our earlier observation that Xt = x + µt + σBt .

Brownian Motion as a Model for Stock Prices?

There are a number of reasons why Brownian motion is not a good model for stock prices:
• Limited liability
• People care about returns, not absolute prices
– so independent increments property should not hold for stock prices
Generating Random Variables and Stochastic Processes 24

7.2 Geometric Brownian Motion

Definition 2 We say that a stochastic process, {Xt : t ≥ 0}, is a (µ, σ) geometric Brownian motion (GBM) if
log(X) ∼ B(µ − σ 2 /2, σ). We write X ∼ GBM(µ, σ).

The following properties of GBM follow immediately from the definition of BM:
Xt2 Xt3 Xtn
1. Fix t1 , t2 , . . . , tn . Then Xt1 , Xt3 , Xtn−1 are mutually independent.
³ ´ ¡ ¢
Xt+s
2. For s > 0, log Xt ∼ N (µ − σ 2 /2)s, σ 2 s .

3. Xt is continuous.
Again, we call µ the drift and σ the volatility. If X ∼ GBM (µ,
¡ σ), then note that
¢ Xt has a lognormal
distribution. In particular, if X ∼ GBM(µ, σ), then Xt ∼ LN (µ − σ 2 /2)t, σ 2 t .

Question: How would you simulate a sample path of GBM (µ, σ 2 ) at the fixed times 0 < t1 < t2 < . . . < tn ?
Answer: Simulate log(Xti ) first and then take exponentials! (See below for more details.)

7.3 Modelling Stock Prices as Geometric Brownian Motion

Note the following:
1. If Xt > 0, then Xt+s is always positive for any s > 0. Why?
− so limited liability is not violated
Xt+s
2. The distribution of Xt only depends on s
− so the distribution of returns from one period to the next is constant
This suggests that GBM might be a reasonable3 model for stock prices. In fact, we will usually model stock
prices as GBM’s in this course, and we will generally use the following notation:
• S0 is the known stock price at t = 0
• St is the random stock price at time t and
2
St = S0 e(µ−σ /2)t+σBt

where B is a standard BM. The drift is µ, σ is the volatility and S is a therefore a GBM (µ, σ) process
that begins at S0
Questions
1) What is E[St ]?
2) What is E[St2 ]?
2
2) Show St+s = St e(µ−σ /2)s+σ(Bt+s −Bt )
.

7.4 Simulating a Geometric Brownian Motion

Suppose we wish to simulate S ∼ GBM (µ, σ). Then as before,
2
St = S0 e(µ−σ /2)t+σBt
,

so it is clear that we can simulate S by simply simulating B.

3 Of course many other models are used in practice for studying various markets.