Final answer:
The Interest Rate Parity Theory proposes that the difference in forward and spot exchange rates between two currencies corresponds to the interest rate differential between the respective countries. This theory helps to equate the returns on investments in different currencies, reflecting expected currency appreciation or depreciation based on these interest rate disparities.
Step-by-step explanation:
The theory that suggests the percentage difference between the forward rate and the spot rate depends on the interest rate differential between two countries is known as the Interest Rate Parity Theory. This concept holds that the difference in interest rates offered by two distinct countries should equal the difference between the forward exchange rate and the spot exchange rate between two currencies. This adjustment in rates serves to equalize the return on investments in different currencies once the expected changes in exchange rates are accounted for.
For instance, if the interest rate in the United States is higher than the interest rate in the European Union, the euro is expected to strengthen against the US dollar in the future. This expectation of currency appreciation affects the demand and supply dynamic, impacting the exchange rates immediately and potentially altering the yields on investments like government bonds.