BA and Iberia, which on Friday posted a wider-than-expected nine-month operating loss, agreed on Thursday to create a group with a combined market value of $7 billion (4.2 billion pounds) in an attempt to cope with the industry's largest downturn in decades.

BA's pension deficit was one of the main stumbling blocks to the 16-month merger talks and was a key negotiating tool for Iberia, which is reserving the right to back out of the deal if the pension hole turns out to be detrimental.

"There's still a risk that the deal will fall through. It's all hanging on BA's negotiating weight with Trustees over its pension," a Madrid-based equities sales trader said.

By 10:40 a.m., Iberia's shares were 1.2 percent lower to 2.19 euros, after Thursday's 12 percent gain, while BA was 1.5 percent higher at 218 pence.

The new company will combine British Airways' strong position in Europe-to-North America traffic with Iberia's Latin American business, and will potentially be reinforced by a planned alliance with AMR Corp's American Airlines.

So far the deal looks set to give BA shareholders 55 percent of the new company, effectively giving it control, but the balance of power remains in question and could shift to Iberia's favour depending on the outcome of BA's talks with trustees over its pension deficit.

The BA-Iberia format mirrors the ground-breaking 2004 merger of Air France and KLM, which airline industry executives describe as a back-office merger designed mainly to slash costs.

Under this model, the airlines would maintain their own fleets and networks, which operate under the banner of national traffic rights, but would be owned by a common holding company.

"This is a five-year plan to get through the crisis and generate cash, and then BA will firmly take the driving seat," said Enrique Quemanda, Chief Executive of boutique investment firm ONEtoONE.

Iberia said its loss before interest and taxes widened to 331 million euros, and was bigger than analysts' average forecast for a 320 million euro (286 million pound) loss, as aggressive cost-cutting was not enough to compensate for a 20 percent fall in revenues.

"Iberia has done some aggressive campaigning to fill its planes, even at cheap fares, and margins have suffered as a result, " an analyst in Spain who asked not to be named said.

The airline swung to a net loss of 181.9 million euros from a 51.1 million euro profit a year ago as the economic crisis continued to dent passenger numbers, Iberia said on Friday.

"The airline industry in Spain is facing exceptionally difficult circumstances," Iberia said.

Iberia carried 5.1 percent fewer passengers in October, while its load factor -- a measure of how full its planes fly -- improved to 80.6 percent.

British Airways posted last week posted a 292 million pound pretax loss and said predicted revenue would slump by 1 billion pounds this year.

The International Air Transport Association expects airlines to lose $11 billion (6.6 billion pounds) in 2009.

(Additional reporting by Rhys Jones and Robert Hetz, Editing by Will Waterman and Erica Billingham)