MUMBAI - The Indian rupee weakened against the dollar on Thursday and the one-year forward premium fell after the central bank announced a swap auction analysts said was aimed at boosting liquidity at local banks and preventing a sharp rise in the exchange rate.

The rupee weakened to 69.68 to the dollar, while the one-year dollar/rupee forward premium fell to 3.63 from 3.89.

The 10-year benchmark bond yield was up two basis points to 7.57 percent as the move reduced expectations for bond purchases by the central bank, traders said.

The Reserve Bank of India said on Wednesday it will conduct a dollar/rupee buy-sell swap auction of $5 billion for a tenure of three years on March 26, the first such market sale by the central bank to mop up dollars and pump in rupees.

"There is always a first for something," said A. Prasanna, head of fixed income research at ICICI Securities Primary Dealership.

"This will achieve multiple objectives including bringing down short-term interest rates for borrowers, helping the RBI to mop up lump sum amount of dollars at one go, infusing liquidity and preventing any sharp appreciation in the rupee in face of a strong pipeline of flows in the near term," he said.

Under the new arrangement, banks can offer to swap dollars for rupees with the RBI at a premium decided by the auction process, which will potentially lower the hedging cost for the lenders, traders said.

In 2013, then central bank governor Raghuram Rajan announced a similar forex deposit swap arrangement at a subsidised market rate to attract dollars and prevent the rupee's free fall during India's worst currency crisis since 1990s.

"The step will also help in improving fund flow to NBFCs (non-bank finance companies) as many investors might bring in dollars lured by a lower hedging cost rate with the RBI and buy 3-year high yielding corporate bonds," said a trader who handles foreign investor funds.

($1 = 69.5900 Indian rupees)

(Reporting by Suvashree Dey Choudhury; editing by Darren Schuettler) ((; +91-22-61807223; Reuters Messaging: