NSW Premier Morris Iemma and federal Attorney-General Philip Ruddock announced on Thursday that the exercise began Wednesday night and would continue for the next three weeks.
The exercise involves more than 250 NSW Police officers, as well as personnel from emergency services, the Australian Defence Force, ASIO and federal police.
Mr Ruddock said the exercise aimed to test Australia's preparedness ahead of next year's APEC meeting in Sydney.
He said it was impossible to predict what type of terrorist attack could occur in Australia, but that an airport hostage situation was one possibility.
"No exercise can directly replicate what we might experience ... but we've got to do the very best to replicate what we think we might have to face," Mr Ruddock said.
"It is very important that exercises occur in the most realistic way possible."
Mr Iemma said NSW would continue to work with the federal government in an ongoing series of counter-training activities.
"We know that the threat can change rapidly so our challenge is to respond and be prepared," he said.