Yes, BOM ( byte order mark) was creating the problem. I was modifying the input instance xml file in textpad and interestingly enough when I save the file, textpad removes preceding BOM (0xff, 0xfe) from the file and Biztalk was throwing exception because of missing BOM. Though there is a work around in textpad to fix this, I would recommend using notepad for modifying the input instance xml.
Thanks a lot for the help guys.