Luther Industries needs to borrow $50 million in cash. Currently long-term AAA rates are 9%. Luther can borrow at 9.75% given its current credit rating

Luther is expecting interest rates to fall over the next few years, so it would prefer to borrow at the short-term rates and refinance after rates have dropped. Luther management is afraid, however, that its credit rating may fall which could greatly increase the spread the firm must pay on new borrowings. How can Luther benefit from the expected decline in future interest rates without exposure to the risk of the potential future changes to its credit ratings bring?

Answer: Luther can borrow at the long term rate of 9.75% and then enter into a swap arrangement where it receives a fixed rate of 9% and pays the short-term rate. In this way Luther locks in its current credit spread of 0.75% but gets the benefit of lower rates if the rates decline.