On June 18, 1985, a major Wall Street investment firm executed a $50 million investment program utilizing simultaneous investments in stocks and stock index futures contracts for a large institutional client. The goal was to enable the client to earn a return of 9.95 percent on its invested cash, about 3 percentage points more than it could earn by investing in Treasury bills, which then were paying 6.95 percent.

On Sept. 20, 1985, when the massive series of trades was closed out, the client realized a net profit of $1.213 million in 94 days.

After commissions and incentives were paid, the client wound up with 9.39 percent return on his money.

For its efforts, the Wall Street firm earned about $202,000.

How did they do it?

By using a modern variation on the old technique of arbitrage. Classically, arbitrage involves buying an item in one market and selling it in another market where the price is higher, profiting from the difference in price. Thus, an arbitrageur might buy gold in London at $320 an ounce and sell it in New York at $322 an ounce, making a $2 profit on each ounce.

To set up its modernized arbitrage program, the Wall Street firm bought what traders call a "basket of stocks" in 487 companies that are part of the Standard & Poor's 500 stock index. The stocks in the basket were selected to mirror the price movements of the S&P 500, which includes industrial, transporation, utility and financial companies. Price movements of these widely traded stocks are calculated in a composite index maintained by Standard & Poor's Corp.

Since 1982, the Chicago Mercantile Exchange has traded futures contracts on the S&P 500 stock index. Similar to agricultural futures, stock index futures allow investors to speculate on the direction of the group of stocks that make up the index. Unlike conventional commodity futures contracts, which can be settled by delivering a carload of grain, stock index futures contracts are settled only in cash instead of in commodities.

At the close of trading on the day that stock index futures contracts expire, their value equals the closing value of the S&P 500 stock index. But at all other times, the value of the stock index future and the stock index itself can move independently, driven by market conditions on the stock markets in New York and the big futures markets in Chicago.

The basket of S&P 500 stocks purchased by the the Wall Street firm cost $50.06 million and included 1.24 million shares of the 487 companies. During the time the stocks were being purchased, the S&P 500 index stood at 187.51.

Simultaneously, the firm sold 534 S&P 500 stock index futures contracts with September 20th expirations. The average price was 190.90.

The difference, or spread, between the 190.90 futures contract value and the 187.51 value of the actual stocks amounted to 3.39 points on the S&P 500 -- in a profit virtually without risk.

During the 94 days the stocks were held, the shares paid dividends equivalent to 1.91 points on the S&P 500 index.

Adding the 3.39 point spread and the 1.91 points from the dividends created a total spread of 5.3 points. Translated into dollars, that equaled a potential profit of about $1.41 million.

The profit is figured by multiplying 5.30 points times $500, the value of each S&P point, times the 534 contracts sold.

On Friday, Sept. 20, when the S&P index futures expired, the arbitrage program was unwound. The Wall Street firm sold its 487 stocks.

The successful unwinding of the trading program depended on selling the stocks at the last sale price of the day so that the total portfolio price matches the closing price of the S&P 500 index that day. To do that, traders place orders to sell their stocks "at the close." When several investment firms are closing out their arbitrage positions on the same day, the rush of last-minute orders can cause wild swings in stock prices.

At the close on Sept. 20, the S&P 500 index settled at 182.05. The stocks had been bought at 187.51, creating a loss of 5.46 S&P points, or $1.46 million. The futures contracts had been sold at 190.90 and expired at 182.05, a gain of 8.85 points, or $2.36 million. That was a net gain of $905,130, plus $510,000 from the dividends collected. The total gain was about $1.41 million, or a return of about 10.98 percent before commissions.

The Wall Street firm charged 5 cents a share to buy and 5 cents a share to sell each share plus a $30 roundtrip commission for each futures contract. The firm and the client also shared an incentive sum, generated when the Wall Street firm made a slightly larger profit than the client anticipated. For masterminding and executing the $50 million deal, the Wall Street firm earned about $202,000.