What concept predicts the foreign exchange rate based on the interest rate differences between two countries?

The concept that predicts the foreign exchange rate based on the interest rate differences between two countries is known as interest rate parity. This theory suggests that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies. Essentially, if one country has a higher interest rate compared to another, it is expected that its currency will appreciate in value relative to the other currency over time.

Interest rate parity ensures that investors cannot make arbitrage profits from discrepancies in interest rates and exchange rates. By investing in the currency with the higher interest rate and covering the currency exposure through a forward contract, investors can lock in a return that reflects the interest rate differential, leading to the prediction of future exchange rates based on these factors.

Understanding this concept is crucial for financial management, as it impacts decisions related to investments, hedging, and overall international financial strategies.