How exchange rates are determined

In FX rates, how do the markets decide at what scrupulous spot rate a currency will trade, or what connection a forward exchange rate should tolerate to the spot rate? To answer this question various economists have forwarded number of theories. Purchasing power parity was the first theory to be developed. It seems naturally believable, that between two currencies the FX rates of each currency should be related to the purchasing power. According to most of the economist, Theory of interest rate parity is the most important theory for how FX rates are determined. For example, a UK investor, having funds in sterling, is free to choose whether to invest in UK or the USA. The rate of interest is 5% on the risk free US government securities while on UK gilts the rate of interest is 3%. This implies that, the FX rate in 12 months should be $1.6310/ pound, if the two currencies can to be stable, that is to say in forward rate and spot rates dollar can be purchase more cheaply. We say that at a forward discount dollars are traded to starlings. The FX rates and interest rates between two countries need to be stable; the currency with higher rate of interest of that country should stand at the forward rate discount against the currency with lower rate of interest of that country.