Derivatives are contracts, whereby two parties agree to a foreign exchange trade at an agreed rate. They do not exchange cash then, but will at some specified time in the future.

For a company which will need to exchange cash on payment for goods sent overseas, this contract removes the risk that the foreign exchange rate will move against them. Banks can protect themselves by doing the foreign exchange trade now and putting the resulting cash on deposit. The value of the cash at the end of the deposit determines the rate at which the original forward was done.

If this isn't clear then don't panic. If all things were obvious, the banks wouldn't make any money.

Entities (eg companies) generate risk, such as currency exchange rates moving or interest rates moving, for example. Large entities concentrate this risk to the point where any sane person would hold up their hand and ask to be let out of the room.

In order to protect themselves from risk, there are markets which can transfer risk from one entity to another (if, for example, the entities had offsetting risks). The value of these contracts is dependant on one or more underlying variables (eg a foreign exchange rate).

These contracts may be relatively simple to value or be complex... and need a clever computer and a brave company to play with them.