MUMBAI, May 9 (Reuters) - Indian forex traders had taken the simmering tensions between India and Pakistan in their stride until Thursday afternoon, when news of a flare-up in the military offensive sent the market into a tizzy and the rupee to its worst day in over two years.

In early trading hours of Thursday, the rupee had nearly recovered all its losses since India's initial strikes in Pakistan and Pakistan-administered Kashmir on Wednesday. But news in the afternoon of Pakistan striking back in a tit-for-tat sparked a rapid shift in sentiment.

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In a spectacular U-turn, the rupee went from its peak of near 84.50 per dollar on the day to end down 1% at 85.71, marking its biggest one-day percentage drop in more than two years.

While the market was counting on Pakistan not retaliating, Thursday's developments have spurred worries about a wider conflict, said Apurva Swarup, vice president at Shinhan Bank India.

"At the same time, the market liquidity is quite thin, which is why there are sharp moves happening right now," Swarup said.

The conflict between the two neighbours has intensified further, with the rupee extending losses to a one-month low of 85.8425 on Friday. The Reserve Bank of India stepped in to support the currency.

The market's nervousness is also reflected in the rise in the dollar-rupee volatility skew, which signals that demand for options betting the rupee will fall has outpaced appetite for options that wager on its rise.

The 1-month dollar-rupee non-deliverable forwards have climbed to their highest in a month, reflecting offshore market participants' concerns about rupee weakness.

Indian bonds and the Nifty 50 equity index also extended their losses on Friday.

India and Pakistan, currently locked in the worst confrontation in more than two decades, have been clashing since India struck multiple locations in Pakistan on Wednesday in retaliation for a deadly attack in its restive region of Kashmir last month.

Pakistan's armed forces launched "multiple attacks" using drones and other munitions along India's entire western border on Thursday night and early Friday, the Indian army said.

The rupee could remain under pressure in the near term, said Dhiraj Nim, an FX strategist and economist at ANZ, as the overnight escalations look "severe".

So far, there is no credible hint of either side backing down or talking down tensions, Nim said.

https://www.reuters.com/world/india/poise-frenzy-rupee-traders-mood-swings-india-pakistan-conflict-flares-up-2025-05-09/