UPDATE 3-Buffett-backed USG rejects buyout offer from Germany's Knauf

* Knauf discloses offer to buy USG for $42/shr

* USG says proposal is "wholly inadequate"

* Berkshire offers 6-month option to sell USG shares to Knauf

* USG jumps 15.3 pct to $38.66 (Adds background, updates shares)

March 26 (Reuters) - U.S. building products maker USG Corp , backed by Warren Buffett, rejected an unsolicited buyout offer from its second-biggest shareholder, Germany's Gebr Knauf KG, saying the offer substantially undervalued the company.

Gebr Knauf disclosed on Monday that it had offered to buy the maker of gypsum wallboards earlier this month for $42 per share, a premium of 25 percent to the stock's Friday closing, valuing the company at about $6 billion.

In response to the offer, Buffett's Berkshire Hathaway Inc , had offered an option sell its 31 percent stake in the company as long as long as Knauf's offered at least $42 a share for USG. Berkshire also proposed an option purchase price of $2 per share.

The option provides a sweetener for Buffett to shed a profitable investment that originated in late 2008, at the height of the housing crisis, when Berkshire and Canada's Fairfax Financial Holdings Ltd bought $400 million of USG's debt.

The $2 per share cost of the option would provide Berkshire about $86.8 million upfront, based on its 43.39 million share USG stake. Berkshire would keep that money even if Knauf proved unable to buy USG.

USG's stock rose as much as 20 percent to $40.10 in early trading, but pared some of those gains to trade at $39.32.

"Knauf's opportunistically timed proposal is wholly inadequate," USG Non-Executive Chairman of the board Steven Leer said.

USG's shares have fallen about 13 percent this year. The company reported a 6.8 percent decline in its 2017 operating profit, hurt by higher costs of raw materials such as gypsum and steel.

Morgan Stanley is the financial adviser to Knauf. J.P. Morgan Securities LLC and Goldman Sachs and Co LLC served as financial advisers to USG. (Reporting by Arunima Banerjee and Ankit Ajmera in Bengaluru; Additional reporting by Jonathan Stempel; Editing by Anil D'Silva and Saumyadeb Chakrabarty)