# Obligation: Legal Definition and Examples in Finance

## What Is Obligation?

An obligation is the responsibility of a party to meet the terms of a contract or agreement. If an obligation is not met, the legal system often provides recourse for the injured party.

### Key Takeaways

*   Obligations are responsibilities, often in the form of a contract, such as a mortgage or auto loan.
*   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.

## Understanding Obligation

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.

Financial obligations represent any outstanding debts or regular payments that a party must make. For example, if you owe or will owe money to anybody, that is one of your financial obligations. Almost any form of payment or financial security represents a financial obligation. Coins, banknotes, shares of stock, and [bonds](https://www.investopedia.com/terms/b/bond.asp) are all promises or obligations that you will be credited with the accepted value of the item or gain certain rights or privileges by holding it.

Many formal financial obligations, like mortgages, student loans, or scheduled service payments are set down in written contracts signed by both parties and establish a creditor-debtor relationship of obligation.

> **Tip**
>
> Money can be construed as a financial obligation mandated by the government as legal tender, obliging producers or vendors to sell goods in exchange for currency such as coins and banknotes.

## Obligation 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](https://www.investopedia.com/terms/f/financial-obligation-ratio-for.asp) (FOR), a quarterly figure released by the [Federal Reserve Board](https://www.investopedia.com/terms/f/frb.asp) 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.

## Obligation Vs. Rights

Obligation means something particular in the world of derivatives, and especially in [options trading](https://www.investopedia.com/options-basics-tutorial-4583012). A [call option](https://www.investopedia.com/terms/c/calloption.asp), for instance, is a financial contract that gives the option buyer the _right_, but _not_ the obligation, to buy a stock, bond, [commodity](https://www.investopedia.com/terms/c/commodity.asp), or other asset or instrument at a specified price within a specific time period. This means that the option holder can decide whether or not to invoke that right, and is not obliged to do so.

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](https://www.investopedia.com/terms/s/strikeprice.asp), but this is not the case. In fact, one of the most attractive aspects of buying a call option versus simply buying a stock is that it gives the trader exposure to a large amount of stock for a smaller amount of money, called the [premium](https://www.investopedia.com/terms/o/option-premium.asp#:~:text=An%20option%20premium%20is%20the,factors%3A%20intrinsic%20and%20extrinsic%20value.).

A [futures](https://www.investopedia.com/terms/f/futures.asp) or [forward](https://www.investopedia.com/terms/f/forwardcontract.asp) contract, on the other hand, assigns both the right _and_ the obligation to deliver or receive the underlying asset or instrument.

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

## Obligation Examples

The failure to meet one's obligations is often met with punishment, the degree of which depends on the character of the contract. For example, 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 allowing the creditor to recuperate some of their losses in the form of assets held by the debtor.

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 their 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](https://www.investopedia.com/terms/a/assignablecontract.asp).

## 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](https://www.investopedia.com/terms/t/totaldebttototalassets.asp), 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."

> **Article Sources**
>
> 1.  Federal Reserve Bank of St. Louis. "[Household Financial Obligations as a Percent of Disposable Income](https://fred.stlouisfed.org/series/FODSP)." Accessed May 26, 2021.