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Theatres are created the same way you would create a Corps HQ or Army HQ, just go up the chain of command. Though in vanilla HOI3 you can't create new theatres, you need the expansions.
Theatres do a bunch of things like provide bonuses to anyone under their command.
If you're using AI control, then the AI will mostly only operate within the provinces you've assigned to the theatre they are in. So if some rebels spawn in France or something, the AI wont pull a tonne of divisions from the Russian front to crush the rebellion.