Default Correlations, Skin in the Game and Insurance: Can Prices be Increasing in Risk?

This paper develops a theoretical model to analyze the pricing of default correlations in securitization markets. I examine how risk retention by investors, known as "skin in the game," interacts with correlation risk to influence the value of senior securities. When correlations between default events are high, investors require more risk retention through subordination to protect against loss, which in turn impacts pricing. The model highlights the endogenous relationship between subordination levels and correlation, providing insights into the pricing of risk in structured finance. JEL classification: G12, G21, C63, D53, G32