Thank God for a short list of direct questions.
Daydreaming occurs when I slowly transition away from the current context--a conversing, walking, reading--and I enter a realm populated by my imagination. During the daydream, I'll extend the context past the actual reality of the situation, or I'll shift gears entirely. It's basically a manifestation of my natural tendency to stop paying attention to what's in front of me and shift into a more interesting world.
The more tired I am and the more boring the current context is, the more likely I am to daydream.
Ever seen Scrubs or Family Guy? Something like that, maybe.