The rupee rebounded by 52 paise to close at 70.72 against the US dollar on Thursday as investors wagered on de-escalation of tensions between India and Pakistan.
Strong foreign fund inflows, a weakening dollar and slipping oil prices also propped up the local unit, analysts said.
In a surprise announcement, Pakistan Prime Minster Imran Khan told a joint session of Parliament that IAF's captured pilot Wing Commander Abhinandan Varthaman will be released on Friday as a gesture of peace.
At the Interbank Foreign Exchange (forex) market, the domestic unit opened slightly up at 71.22. It rose to an intra-day high of 70.70, before finally ending at 70.72, showing a gain of 52 paise.
The domestic currency had tumbled 17 paise to 71.24 against the US dollar on Wednesday.
"India rupee gained after two days of weakness against American dollar on chances of de-escalation of tension with Pakistan. Beside dollar weakness, the foreign fund inflows in domestic equity and lower crude oil prices bode well for rupee.So far this month, overseas investors have bought USD 2.31 billion in domestic equity," said V K Sharma, Head PCG and Capital Markets Strategy, HDFC Securities.
The dollar index, which gauges the greenback's strength against a basket of six currencies, dropped 0.22 per cent to 95.94 as US President Donald Trump's summit with North Korean leader Kim Jong Un ended without an agreement.
The pound slipped from its highest against the dollar since July and a 21-month high against the euro after opposition Labour Party's alternative plan was rejected.
Meanwhile, foreign investors (FIIs) remained net buyers in the capital markets, putting in Rs 3,210.60 crore on a net basis Thursday, as per provisional data.
Brent crude futures, the global oil benchmark, slipped 0.92 per cent to USD 65.83 per barrel on rise in US crude oil output and weaker Chinese manufacturing data.
The BSE benchmark Sensex ended marginally lower on Thursday after investors squared-off positions as February derivative contracts expired.
The 30-share index dropped 37.99 points, or 0.11 per cent, to close at 35,867.44. The broader NSE Nifty also fell 15.70 points, or 0.13 per cent, to 10,792.50.
Meanwhile, the Financial Benchmark India Private Ltd (FBIL) set the reference rate for the rupee against the dollar at 71.1953 and against euro at 80.9790.
The reference rate for the rupee against the British pound was fixed at 94.7021 and against 100 Japanese yen at 64.24.