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* FTSEurofirst closes down 0.1 percent
* Cyprus deal possible within hours
* Investors sceptical, defensives lead risers
* Banks remain under pressure, debt costs rising
By David Brett
LONDON, March 22 (Reuters) - European shares ended only marginally lower on Friday as investors largely expected a deal would be struck to bail out deeply-indebted Cyprus and prevent an escalation of the euro zone debt crisis.
The FTSEurofirst 300 closed down 1.28 points, or 0.1 percent at 1,189.44, while the euro zone blue chip index was flat at 2,681.67, although all major European indexes ended the week in negative territory.
"It has been a bumpy week but indices are still absorbing bad news relatively easily," Dominic Hawker, analyst at Messels, said.
An announcement late on Friday by the deputy leader of Cyprus's ruling Democratic Rally party that a solution to the island's bailout crisis within the framework set down by the European Union may be possible within "the next few hours", helped stabilise indexes.
Bank of America Merrill Lynch remained optimistic a deal for Cyprus would be reached and expected the Euro STOXX 50 to rebound back towards 2,750 points, but scepticism remained among some investors.
"The cynic in me says the market is building itself up for disappointment, as any potential deal would then have to be approved by troika (the EU, the ECB and IMF)," a London-based trader said.
Cyprus needs to find 5.8 billion euros ($7.5 billion) in new money by a Monday deadline to clinch a European Union bailout, having earlier rejected a plan to raise the funds by taxing bank customers' deposits. If it cannot do so, it risks a collapse of its financial system that could push it out of the euro zone.
Mike Turner, European equity options broker at XBZ Ltd, said clients had been buying protection against potential market falls, should Cyprus disappoint markets over the weekend and fail to come to an agreement.
He said investors had been buying "puts" - which give the right to sell an index in the future - on the Euro STOXX 50 due to expire next week with strike prices ranging from 2,600 to 2,500 points - implying that some saw a possible 7 percent fall on the Euro STOXX 50 over the course of next week.
While equity markets appeared to take the threat from Cyprus in their stride, other areas of the market were emitting signs of stress as the risk to write downs for Europe's larger creditors troubled for credit investors.
"Cyprus has had a deleterious impact on financial credit costs ... The sharp rise in the CDS - the cost of insuring against a default on a loan -- of German companies suggests that a resolution to the current round of the euro crisis may require more haircuts for creditors, or German taxpayers being forced to pay up," Olive Tree Financial Group said in a note.
Over the past week, bank share prices have become much more inversely correlated with CDS levels than at any time in the past eight weeks.
Investors cautiousness was reflected in their choice of asset purchases on Friday with mainly defensive stocks - companies which offer goods and services consumers rely on even in an austere economic climate - leading the gainers.
Utility firms rose 0.8 percent, with German power provider E.ON up 1.2 percent, helped by Exane BNP Paribas' upgrade to "neutral" on valuation grounds.
Telecoms, sought after for their 6 percent yield, rose 0.6 percent, led by Telecom provider BT, up 3.9 percent, which had its target price hiked to 360 pence from 290 pence by Nomura.
"Regulatory rhetoric is turning positive for all of Europe's network owners, but the benefits should prove more tangible for fixed networks and highly significant for BT," the investment bank, which also repeated its "buy" rating on valuation grounds, said in a note.
Healthcare climbed 0.2 percent, led by AstraZeneca which rose 3.3 percent as Natixis lifted its recommendation on the drugmaker to "neutral" after the firm's chief executive laid out his plans to turnaround the company on Thursday.
The anomaly was the riskier oil and gas sector, which climbed 0.4 percent, although the majority of those gains were down to sector heavyweight BP.
The oil major rose 1.8 percent after it said it would return $8 billion to shareholders, which helped cushion equity markets from bigger losses.
And Italy's benchmark FTSEMIB rose 0.7 percent on optimism the uncertainty over the leadership of the country, currently in limbo, would soon be resolved.