Which theory states that the difference in interest rates between two countries is equal to the difference between the forward and spot exchange rates?

The concept that establishes a relationship between the interest rates of two countries and the exchange rates is known as interest rate parity. This theory posits that the differential in interest rates for financial instruments of similar risk in different countries is equal to the differential between the forward exchange rate and the spot exchange rate.

In essence, if one country has a higher interest rate compared to another, the currency of that country is expected to depreciate in the future relative to the other, as per the expectations laid out in interest rate parity. This means that if an investor tries to take advantage of these differences in interest rates through arbitrage, any potential gain from the higher yield in the country with the higher interest rate will be offset by the expected decline in the currency's value.

By ensuring that the equality holds between the interest rate differential and the exchange rate differential, interest rate parity helps to eliminate arbitrage opportunities that might otherwise arise due to discrepancies in interest rates and foreign exchange metrics. This balance is crucial for maintaining a stable and predictable international financial system.