What Is Obligation?

What Is Obligation?

Let me tell you directly: an obligation is the responsibility you or any party has to meet the terms of a contract or agreement. If you don't fulfill it, the legal system usually gives the other side some way to seek recourse.

Key Takeaways

You should know that obligations are responsibilities, often tied to contracts like mortgages or auto loans. The Financial Obligation Ratio from the Fed is a solid benchmark for your household budgeting. If you fail to meet obligations, expect punishments such as imprisonment or fines. Tools like debt, liquidity, and solvency ratios help measure a firm's ability to handle its debt obligations.

Understanding Obligation

Obligations are the backbone of our economy—you can see that trusting contracts will be followed creates a stable society. Whether you're an individual, corporation, government, bank, or any entity in society, you must fulfill your obligations or face punishment.

Financial obligations are any outstanding debts or regular payments you have to make. For instance, if you owe money to someone, that's a financial obligation. Things like coins, banknotes, stocks, and bonds are all forms of promises or obligations that give you value or rights.

Many of these, like mortgages, student loans, or service payments, are formalized in written contracts that create a creditor-debtor relationship.

Tip on Money as Obligation

Consider this: money itself is a financial obligation enforced by the government as legal tender, meaning producers or vendors must accept it for goods.

Obligation and Personal Finance

In personal finance, obligations are critical—your budget should always start with listing all the financial responsibilities you have for a given period. The Financial Obligation Ratio (FOR), released quarterly by the Federal Reserve, estimates household debt payments against disposable income and serves as a useful guide for your own budgeting.

You need to assess these carefully, especially for long-term planning like retirement. Over extended periods, factor in obligations such as mortgage interest rates or future healthcare costs.

For reference, the recommended FOR was 14.7 for the last quarter of 2020.

Obligation Vs. Rights

In derivatives, especially options trading, obligation has a specific meaning. A call option gives you the right, but not the obligation, to buy a stock, bond, or other asset at a set price within a time frame—you decide if you want to exercise it.

Investors sometimes get this wrong, thinking a call option forces you to buy stock at the strike price, but that's not true. Actually, buying a call option is appealing because it exposes you to a large amount of stock for just the premium cost, less than buying the stock outright.

Contrast that with futures or forward contracts, which give both the right and the obligation to deliver or receive the asset.

Important Note on Non-Financial Obligations

Remember, obligations aren't only financial—for example, a politician has an obligation to represent their constituents faithfully.

Obligation Examples

Failing to meet obligations often leads to punishment based on the contract's nature. If you miss car payments, the company repossesses the car.

Taxes are another obligation—skip them, and you face large fines or jail time. Big companies unable to pay debts can declare bankruptcy, relieving some debt while creditors recover from the debtor's assets.

Any individual or entity in a contract holds obligations, which can be written or unwritten. A politician has a written duty to serve constituents legally, but might have unwritten ones to donors—these are hard to prove and regulate. Legal systems since the Romans have enforced key contracts strictly.

What Are Collateralized Debt Obligations?

A collateralized debt obligation (CDO) is a complex structured finance product backed by pools of loans and assets, sold to institutional investors. As a derivative, CDOs played a big role in the 2007 housing crisis.

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

The debt ratio—total debt to total assets—gauges how well a firm can meet obligations. Liquidity and solvency ratios are also standard for this.

What Obligations Does the Federal Government Have to the States?

The federal government must guarantee each state a republican government, protect against invasion, and, if requested by the state's legislature or executive, shield against domestic violence.

What Are Reasons for Terminating Contractual Obligations?

You can legally end contractual obligations for reasons like fraud, breach of contract, mutual agreement due to a mistake, or impossibility of performance.