There are many myths that describe the origins of the faeries, and almost all of them are different. Many involve Christianity in some way, these are generally believed to be later myths created by priests to explain the pagan creatures of the wood. These are a few of the more popular origin theories.
In one myth faeries were originally immortal beings who lived in Italy, as the Roman empire spread, so did the little folk, to France, and then to the British Isles. Faeries were kept out of Greece by competition with the indigenous Nymphs and Dryads. In Cornwall they also met with armed resistance from pixies, who managed to keep them from spreading in to that area. Originally Faeries bestowed gifts upon newborn children, while punishing mean adults, but they expanded to interfere in all parts of human life.
In a more likely myth, faeries are the spirits of the dead. This is supported by the fact that faeries are usually considered to live under large hills, many of which are the same mounds under which the ancient Celts buried their dead. An additional connection is that like the dead realm of Hades, faerie food must never be eaten, for once tasted, a mortal can never leave.
Possibly the earliest myth concerning the origin of Faeries is that they are the elemental nature spirits of the trees, hills, and waters. Originally the Celtic 'Elf' referred to this creature, but was possibly replaced with fay and eventually faerie. The Celts had different names for spirits of different areas, for instance feld-elfen, wudu-elfen, berg-elfen and sae-elfen referred to elves of the field, wood, mountain and sea. The wood elves of Celtic origin are more recently considered a sub-type of faerie.
An attempt to interpret faeries in modern terms using the sciences of archaeology and sociology, explains faeries quite nicely (and rather boringly) as the legend of an aboriginal, stone-age rage, first encountered by the invading iron-wielding Celts. The smaller race, which would of-course be beaten by the stronger, more advanced invaders, would be quite fearful of the iron weapons of the invading race. This would explain the two most popular traits of faeries, their by now exaggerated diminutive size, and fear of iron. The larger race, might even be responsible for myths of giants as their size and power also became exaggerated through the years. A very tidy little myth explanation brought to you by science.
In Norse mythology, maggots emerging from the corpse of the giant Ymir transformed themselves into the Light Elves and Dark Elves. Living in the air, the Light Elves were happy and benign, but the Dark Elves who dwelt underground were evil and malicious.
The Icelandic (post Christianity) myth tells that Eve was washing her children in a river, and God spoke to her, fearful of him, Eve hid all of her unwashed children. God asked her if all of her children were there, and Eve replied that they were. God then said that all of the children which she hid would remain hidden from man, and would become the elves, faeries and Huldre Folk (Scandinavian). The Huldre girls were very beautiful, but only from the front.
In the post Christianity myths, faeries are the spirits of unbaptized children or fallen angels or ancient druids who grow smaller and smaller through the ages, refusing to become Christians. In all of these cases, they are not good enough for heaven, but too good for hell. So they are expelled to live in the middle world.