Air Arabia Abu Dhabi will be an independent joint venture based at Abu Dhabi International, the hub of Abu Dhabi state-owned Etihad, the two carriers said in a statement.
It will be the capital's first budget carrier.
"This exciting partnership supports our transformation programme and will offer our guests a new option for low-cost travel to and from Abu Dhabi, supplementing our own services. We look forward to the launch of the new airline in due course," said Etihad Group CEO Tony Douglas.