British Airways and Iberia are holding talks on an "all-share" merger between the two carriers.
The news comes as BA is preparing to release its first quarter results on Friday (August 1) which analysts predict will reveal a sharp drop in profits.
The merger talks are backed by both airlines' directors and if the deal goes ahead, both brands would be retained.
A statement by BA also revealed that Iberia, the Spanish national carrier, had "recently" bought a 2.99% stake in the British airline.
The statement said that Iberia had also acquired "financial exposure to a further 6.99% through contracts for difference linked to British Airways' share price."
BA bought a 9% holding in Iberia in 1999 and increased this to 13.15% earlier this year.
BA was also part of a consortium which tried to buy Iberia last year.
The deal fell through when other shareholders indicated they wanted the carrier to remain in Spanish hands.
BA and Iberia are both members of the oneworld alliance and have worked together for many years.
The two airlines are also in talks with another oneworld partner American Airlines over a possible application for anti-trust immunity to the US Department of Transportation.
Willie Walsh, BA's ceo, said of the merger talks: "The aviation landscape is changing and airline consolidation is long overdue.
"The combined balance sheet, anticipated synergies and network fit between the airlines make a merger an attractive proposition, particularly in the current economic environment.
"We've had a successful relationship with Iberia for a decade and are confident that both companies' shareholders would benefit from the proposed tie-up."
Fernando Conte, Iberia's chairman and ceo, said: "A merger would be good news for our customers and enhance our existing relationship.
"We've worked together for nearly 10 years and a tie-up would build on that success.
"It would also strengthen the oneworld alliance and further develop Madrid's position as the European gateway to Latin America."
The merger talks are expected to last several months before any agreement is reached.
But BA said both parties were "confident of securing regulatory approval" noting that the EU had recently given BA and Iberia approval to co-operate on a wide front.