Which theory suggests that the difference in interest rates between two countries equals the difference between forward and spot exchange rates?

The theory that describes the relationship between interest rates and exchange rates is known as interest rate parity. This economic principle states that the difference in interest rates between two countries will be reflected in the forward exchange rate of their currencies compared to the spot exchange rate. In essence, if one country has a higher interest rate than another, its currency is expected to depreciate in the future, thus maintaining equilibrium in the foreign exchange market.

The concept is based on the assumption that investors should expect to earn the same return on similar risk investments, regardless of the currency in which they are denominated. For instance, if an investor can earn a higher interest rate in a foreign currency, the currency's forward rate should be lower than the spot rate to offset the interest rate advantage. This relationship helps in ensuring that there is no arbitrage opportunity, where investors could make risk-free profits from discrepancies in exchange and interest rates.

Understanding interest rate parity is crucial for traders and investors dealing with foreign currencies, as it informs their expectations about future currency movements based on current interest differential conditions.

In contrast, the other options address different concepts; for instance, exchange rate forecasting relates to predicting future rates through various models, currency risk measurement focuses on assessing the potential loss due to