Explanation

Correct Answer: B

Monte Carlo simulation involves sampling from an assumed multivariate distribution that is calibrated using historical returns. This approach generates random scenarios based on statistical distributions rather than relying solely on historical data.

Analysis of Other Options:

• A: Incorrect - Bootstrapping is used in historical simulation, not Monte Carlo simulation. Monte Carlo uses parametric distributions.
• C: Incorrect - If actual returns are negatively skewed and a multivariate normal distribution is assumed, Monte Carlo would actually underestimate true downside risk, not overestimate it. Normal distributions are symmetric and cannot capture negative skewness properly.

Key Points:

• Monte Carlo simulation uses parametric distributions calibrated to historical data
• It can incorporate various distributional assumptions beyond normality
• The method generates random scenarios rather than resampling historical data