Definition of naked credit default swap

A naked credit default swap (CDS) purchase means that you take out insurance on bonds without actually owning them.  It is a purely speculative gamble.

Example

CDSs are over-the-counter contracts negotiated by two parties. They offer the buyer insurance on a bundle of underlying securities. A typical bundle would be €10m worth of Greek government bonds. To insure against default, the buyer of a CDS pays the seller a premium, whose value is denoted in basis points.  In early 2010, a CDS contract on five-year Greek bonds was quoted at 394 basis points. This means that it costs the buyer €394,000 per year, for five years, to insure against default. If Greece defaults, the buyer gets €10m, or some equivalent. What constitutes default is subject to a complicated legal definition. [1]

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