There is a relationship between the money market and the foreign exchange market and there are five major theories that can be used to determine exchange rate levels. An efficient exchange market exists when exchange rates reflect all available information and adjust quickly to new information. This removes all profits in excess of the minimum from the system. It depends on three hypotheses: 1.      Market prices, such as product prices, interest rates, spot rates, and forward rates, should reflect the market’s consensus estimate of the future spot rate. 2.      Investors should not earn unusually large profits from forward speculation. 3.      It is impossible for any market analyst to beat the market consistently. The Theory of Purchasing Power Parity states that the equilibrium exchange rate between domestic and foreign currencies equals the ratio between domestic and foreign prices. The PPP theory can be used to forecast exchange rates. The Fisher Effect states that the nominal interest rate of each country is equal to a real interest rate plus an expected rate of inflation. Real interest rates are equalized across countries through arbitrage. The theory works well for short-term government securities. However, the theory suffers from an increased financial risk inherent in fluctuations of a bond market value prior to maturity, by the unequal creditworthiness of the issuers, and from the fact that long-term rates are not the sensitive to price changes. The International Fisher Effect describes that the future spot rate should move in an amount equal to, but in the opposite direction from, the difference in interest rates between two countries. It is also hold that the interest differential between two countries should be an unbiased predictor of the future change in the sport rate. The Theory of Interest-Rate Parity notes that the spread between a forward rate and a spot rate should be equal, but opposite in sign, to the difference in interest rates between two countries. The Forward Rate and the Future Spot Rate states if speculators think that a forward rate is higher than their prediction of a future spot rate, they will sell the foreign currency forward. These speculative transactions will bid up the forward rate until it reaches the expected future rate thereby removing any incentive to buy or sell a foreign currency forward. In the absence of predictable exchange market intervention by central banks, an expected rate of change in a spot rate, differential rates of national inflation and interest, and forward premiums or discounts are all directly proportional to each other.

Reference http://209.85.173.132/search?q=cache:-L9-4fQuAEEJ:www.pages.drexel.edu/~chiangtc/InternationalParityConditionsMarketRisk_Encycloped.pdf+five+parity+condition&cd=26&hl=en&ct=clnk&gl=us