Cointegration, causality and domestic portfolio diversification in the Cyprus Stock Exchange

In this paper we provide an investigation on the potential benefits that may exist for portfolio managers, private and institutional investors from domestic portfolio diversification. We employ daily data for the period 1996-2002 from the Cyprus Stock Exchange, recently established emerging market. Cointegration as well as linear and nonlinear causality analysis is used in order to reveal whether there are benefits from domestic portfolio diversification. The cointegration analysis leads to the conclusion that we are unable to reject the null hypothesis of no cointegration in most bivariate cases of the 56 pairs of sectoral indices and this finding is taken to imply that the are benefits from portfolio diversification, when domestic investors construct portfolios which include stocks from the sectors which are not cointegrated. Furthermore, the application of linear and nonlinear Granger causality leads to a pattern of causality between these pairs of sectoral indices which is almost identical and therefore the linearity hypothesis is rejected. Furthermore, based on our causality analysis we provide evidence that traders and investors in the CSE set up short-run investment strategies. Moreover, this implies that the Cypriot investors do not adopt contrarian and momentum investment strategies. Therefore, we argue that the investors in the Cyprus stock market exhibit myopic investment behaviour.