A derivative financial instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between the parties.
For example, When Fannie Mae sold all those home mortgages to Goldman Sachs; Goldman Sachs sold derivatives (insurance) to investors all around the world. Many investors wanted insurance that they would still get their principal back if the mortgage loans defaulted. For a fat fee, Goldman gave them a derivative contract which is really only an insurance policy.
Goldman reinsured themselves for a lesser fee with AIG. Goldman executives gave themselves huge bonuses in the millions with the fees earned and saved (reserved) almost nothing in case the loans defaulted.
When many sub-prime and other mortgage loans stopped paying, the secretary of the US Treasury, who happened to be the former chairman of Goldman Sachs, used taxpayer money to give to AIG to give to Goldman to give to the investors. Rather than let AIG, Goldman and a whole bunch of other big institutions take their losses or go into bankruptcy, the US taxpayer was forced to pay for greedy irresponsible behavior of a bunch of incompetent/unethical bankers.
Since the US government, now mostly through the supposedly private Federal Reserve, continues to bail out banks and other financial institutions around the world, financial institutions continue to sell derivatives promising to mitigate risk in every conceivable type of financial transaction. Institutions are making a lot in fees and generally continue do not have the reserves (money) to make payments if there are defaults.
The total monetary value of derivatives outstanding in the world is more than five times the amount of the world’s total production (GNP). As long as the US government or Federal Reserve Board (FED) continues to bail out the financial institutions, they will continue to sell derivatives that they do not have the monetary reserves to pay in cases of default.