Derivatives are financial contracts, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g.,commodities, equities, stocks, residential mortgages, commercial real estate, loans, bonds).
Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.
HedgingDerivatives massively leverage (leverage is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified) debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression
Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by legendary investor Warren Buffett. He called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.
See also Wikipedia: Derivatives