Which theory asserts that the difference in interest rates between two countries equals the forward-spot exchange rate differential?

The theory that asserts the difference in interest rates between two countries equals the forward-spot exchange rate differential is known as interest rate parity. This concept is fundamental in international finance and asserts that the forward exchange rate should incorporate the interest rate differential between the two countries to prevent arbitrage opportunities. In other words, if investors can borrow in one currency at a lower interest rate than what they would receive on the other currency, they would take advantage of the differences until the rates align, ensuring that gains from interest in one currency offset any losses incurred due to exchange rate fluctuations. This equilibrium leads to the conclusion that the expected change in exchange rates over a given period should mirror the differential in interest rates between the two countries, thus establishing a stable framework for currency exchange and investment decisions.

The other theories mentioned revolve around different principles. Currency speculation involves anticipating future changes in exchange rates without necessarily tying them directly to interest rate differentials. Capital asset pricing engages in assessing expected investment returns against risk factors rather than focusing on exchange rates. Risk premium theory addresses compensation required for bearing risk rather than specifically relating to interest rate and exchange rate relationships. These focuses distinguish them from the central premise of interest rate parity.