The first approach is that analysts focus on flows of export and imports to establish what the net trade flows are and how large they are relative to the economy and other, potentially larger financing and investment flows. The approach also considers differences between domestic and foreign inflation rates that relate to the concept of purchasing power parity. Under PPP, the expected percentage change in the exchange rate should equal the difference between inflation rates. The approach also considers the sustainability of current account imbalances, reflecting the difference between national saving and investment.
The second approach is that the analysis focuses on capital flows and the degree of capital mobility. It assumes that capital seeks the highest risk-adjusted return. The expected changes in the exchange rate will reflect the differences in the respective countries’ assets’ characteristics such as relative short-term interest rates, term, credit, equity and liquidity premiums. The approach also considers hot money flows and the fact that exchange rates provide an across the board mechanism for adjusting the relative sizes of each country’s portfolio of assets.
Source by CFA reading materials