When a portfolio manager goes long a basket of stocks (that make up an index) and hedges his market risk by shorting the corresponding index future, what is his source of potential profit?
He cannot hope to profit/lose by the appreciation of his stocks, since any move in his stock long position is cancelled by the corresponding move in his short futures position.
So that leaves what,dividends? Is that the only way this portfolio would profit?
I know some derivative markets work like this, so maybe similar with futures.
A futures contract commits two parties to a buy/sell of the underlying securities, but with a futures contract you also create leverage because generally the margin you post on your futures contract is not sufficient to pay for the collateral in the underlying contract. The person buying the future is essentially "borrowing" money while the person selling the future is essentially "lending" money. The future you enter into is generally a short term contract, so a perfectly hedged lender of funds should expect to receive something that approaches the fed funds rate in the US. Today that would be essentially nothing.
They profit from the difference in the interest rates between the index and USD. Let's say you bought $1000 of some index and short $1000 worth of the index futures. Then you will get interest from the index (some can be higher than 100% annually), and pay interest for USD (usually not more than 5%). To close the positions, just sell the index and buy back futures, then you will receive $1000 and all the interest you earned during the period.
