What Is an Obligation?

An obligation in finance is the responsibility of a party to meet the terms of a contract. If an obligation is not met, the legal system often provides recourse for the injured party. Financial obligations are the backbone of our economy. Trusting that a contract will be adhered to helps create a stable, healthy society.

Individuals, corporations, governments, banks, and institutions—any entity that operates within a society—must regularly fulfill their obligations, or else face punishment.

Key Takeaways

  • Obligations are usually considered financial responsibilities, often in the form of a contract, such as a mortgage or auto loan.
  • Money is also an obligation, such as coins and banknotes.
  • For budgeting purposes, obligations are important to understand and manage. The Financial Obligation Ratio published by the Fed is a good benchmark for household budgeting.
  • Failure to meet obligations is often met with punishment, such as imprisonment or fines.
  • Debt, liquidity, and solvency ratios are all used to measure a firm's ability to meet its debt obligations.

How an Obligation Works

Financial obligations represent any outstanding debts or regular payments that you must make. If you owe or will owe money to anybody, that is one of your financial obligations. Almost any form of money represents a financial obligation. Coins, banknotes, or bonds are all promises that you will be credited with the accepted value of the item. Most formal financial obligations, like mortgages, student loans, or scheduled service payments are set down in written contracts signed by both parties.

Obligations and Personal Finance

Obligations are an important aspect of personal finance. Every budget should first include all financial obligations for which the individual is responsible over the given time period. The Financial Obligation Ratio (FOR), a quarterly figure released by the Federal Reserve Board that estimates the ratio of household debt payments to disposable income, is a useful benchmark for individual budgets.

Assessing obligations carefully is especially important for retirement planning. When planning over longer periods of time such as retirement or for your child's college fund, the individual budgeter should consider more long-term obligations such as interest rates on mortgage payments or healthcare costs that have yet to be incurred.

14.7

The recommended financial obligation ratio for the last quarter of 2020.

Obligations vs. Rights in Options Trading

Before entering into the high-risk—high-reward world of options trading, one should have a firm understanding of how the term obligation applies to purchasing a call option. Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity, or other asset or instrument at a specified price within a specific time period.

Options trading can be complicated and investors sometimes mistakenly believe purchasing a call option requires you to buy a certain amount of stock at the strike price, but this is not the case. In fact, one of the most attractive aspects of buying a call option vs. simply buying a stock is that it gives the trader exposure to a large amount of stock for a smaller amount of money.

Special Considerations

The failure to meet obligations is met with punishment, the degree of which depends on the character of the contract. If an individual fails to make their car payments regularly, the auto company will repossess the car.

Taxes, too, are a form of obligation, and failing to meet them results in large fines or imprisonment. When large companies fail and find themselves unable to fulfill their outstanding debts, they can declare bankruptcy, which initiates the relief of the total debt for the debtor while giving the creditor an opportunity to recuperate some of their losses in the form of assets held by the debtor.

Obligations aren’t just financial, such as the case of a politician’s obligation to faithfully represent their constituents.

Obligations can be held by any individual or entity that is engaged in any sort of contract with another party, and broadly speaking, can be written or unwritten. A politician, for example, has the written obligation to serve all of his constituents within the confines of the law, but they may also have an unwritten obligation to make decisions that will affect their largest donors.

The existence of these kinds of agreements is nearly impossible to prove and such obligations cannot be effectively regulated. Justice systems dating back to the Romans have offered stringent legal enforcement of important contracts.

Obligation FAQs

What Are Collateralized Debt Obligations?

A collateralized debt obligation or CDO is a complex structured finance product backed by a pool of loans and other assets that are then sold to institutional investors. CDOs are a type of derivative and played a significant role in the 2007 housing crisis.

What Ratios Measure a Firm's Ability to Meet Its Current Debt Obligations?

The debt ratio, which is defined as the ratio of total debt to total assets, is often used to measure how likely a financial institution is to meet its obligations. Liquidity and solvency ratios are also commonly used for the same purpose.

What Obligations Does the Federal Government Have to the States?

The federal government is obligated to guarantee each state a republican form of government, protect each state from invasion, and, when expressly asked by the state's legislature or executive, to protect the state against "domestic violence." 

What Are Reasons for Terminating Contractual Obligations?

Contractual obligations can be legally terminated for any of the following reasons: fraud, a breach of contract, if both parties agree to end the contract due to a mutual mistake, or a legal term known as "impossibility of performance."