An obligation, in a broad sense, refers to a concept of being in need to do something by agreement. There are always two or more participants involved, as an obligation means that a person or an entity has to do something in favor of another person or entity.
In finance, an obligation usually implies debt responsibilities, or the need of one party to pay a certain sum of money to another party.
Importance of Obligation
Since agreements have always been one of the core principles of our society, the fulfillment of obligations is critically important for efficient human relationships on all levels. Without obligations of different kinds, it’s impossible to build a complex working system in any sphere involving many parties interested in different goals.
Obligations of an individual or an entity serve as a basis for future budget planning, and they are also considered by financial institutions for decision-making, so it’s critically important to control it and manage it soundly. The debt ratio is a fine way to measure one’s obligations.
Traditionally, obligations in financial area are established by the written agreements, or contracts, which must be signed by all parties, and sometimes certified in specific cases. Non-written agreements also exist, but they might cause problems connected with difficulties of their verification in case of non-fulfillment. It’s impossible to prove the existence of such an obligation if one of the parties refuses to follow the terms, thus causing an inconvenient situation. For that reason, a written and signed document representing all details of the agreement is required for any important obligation.
An obligation always implies a retribution in case the obliged party doesn’t fulfill an obligation, which serves as a motivation for one party and as a protection for another one. A retribution, or a punishment for a failure to fulfill the obligation, depends on the contract, and there are various possible types, from repossessing of the property used as collateral, to fines or imprisonment. Declaring bankruptcy is one of the ways of dealing with the impossibility to meet an obligation. In some cases, it helps to minimize negative effects for both parties.
There are also legal ways to put an end to an obligation. An obligation might be considered invalid if any kind of criminal activity is involved, or if the parties agree to terminate the contract, or in case there are insuperable circumstances making an obligation impossible to meet, but such cases should be considered by the court.
Obligation instances in finance
In the financial sphere, a vast majority of activities are based on obligations, usually in a form of debt or a payment. As a matter of fact, almost any financial activity involving two parties represents an obligation - if you have a mortgage, it is an obligation to pay regularly to the bank.
Other financial activities can also be presented as obligations. If you purchase a good or a service, you have to pay a certain amount of money for it, which is also an obligation. Taxes are also a clear form of an obligation. Even money itself might be viewed as an obligation - it implies that sellers have to accept that as a medium of exchange and vend their products for it. Similarly, many financial instruments are obligations based on agreements, according to which, again, one party has to pay to another one under certain circumstances.
A collateral debt obligation (CDO) is one more significant example of obligations in finance. This is a financial tool which played a major role in the financial crisis of 2007. In short, a collateral debt obligation represents loans of individuals reformed into products for investments, which are then sold as financial instruments.
Obligations or rights
It’s important to understand the difference between an obligation and a right, which might be particularly crucial in finance. For instance, this difference is important in trading certain financial derivatives such as options, futures and forwards. It’s worth studying this issue in more detail.
Options grant their owners a right, but not an obligation, to buy or sell assets at a certain price stated in the contract. Some might think that an owner of an option has to buy or sell an asset, but the distinctive feature of options is that it’s not necessary. While futures and forwards contracts provide an obligation, which makes them radically different from options, and it’s necessary to remember this when starting trading the abovementioned financial derivatives.