Pakistan's third missile test and a blunt speech by President Pervez Musharraf has unnerved investors about the rising tensions with India.

Stock markets in both countries dropped almost 2.5% over fears of war between the nuclear-armed neighbours.

Musharraf's speech has been harder than what the market had hoped

Sanjeet Singh ICICI Securities and Finance

In a television address, President Musharraf said Pakistan did not want war, but would respond "with full might" if attacked.

The benchmark Bombay 30-share index closed down 2.9% at 3,148 points, while the Karachi Stock Exchange 100-share index shut 2.5% lower at 1,673.

The Indian index has lost almost 8%, hitting six-month lows, since the crisis began two weeks ago.

Pakistan's stock market had been Asia's best performing exchange this year, before losing over 15% and then recouping 12% by Monday's close.

Tough talk

"Musharraf's speech has been harder than what the market had hoped," said Sanjeet Singh, an analyst at ICICI Securities and Finance Company.

"These statements have made the market apprehensive that the issues between India and Pakistan will not be resolved soon."

Pakistan added to the tensions by announcing it had test-fired a short-range surface-to-surface missile, its third since Saturday.

The current crisis began after more than 30 people were killed in an attack on an Indian army camp in Kashmir on 14 May.

New Delhi accuses Pakistan of training and arming separatists in Indian-ruled Kashmir, the country's only Muslim-majority state.

One million troops from India and Pakistan are massed along the border in a tense stand-off that has brought them to the brink of a fourth war.