UPDATE 1-S.Korea orders Lone Star head to stay 10 days-paper

(Adds prosecutor response, background, share price)

SEOUL, Jan 10 (Reuters) - South Korea prosecutors have banned U.S. private equity house Lone Star's chairman from leaving the country for 10 days as he testifies in a local court to defend the head of its Korean operations, a newspaper said on Thursday.

The Chosun Ilbo daily said that John Grayken, founder and chairman of the Dallas-based fund, was handed the travel restriction upon his arrival in the country late on Wednesday.

The Supreme Prosecutors' Office declined to confirm the report, saying it cannot comment on matters under investigation.

Justice Ministry, which gives the final approval to overseas trip bans, also declined to comment, while Grayken's lawyers could not immediately be reached.

The Chosun Ilbo report did not give the reason for the ban, but prosecutors have tried to question him in relation to charges that a former CEO of Korea Exchange Bank (004940.KS) and a former Finance Ministry official colluded to understate the bank's value so it was sold for about a third less than it was worth in 2003.

No Lone Star officials have been directly implicated in that case.

Yonhap News' Web site (www.yonhapnews.co.kr) showed video of Grayken's arrival at Incheon International Airport.

"I'm here voluntarily at the request of lawyers defending Paul Yoo to testify," he told reporters at the airport, but he refused to comment further until he gives his testimony, set for Friday morning.

Yoo has been standing trial since prosecutors charged him in late 2006 of driving down the stock price of KEB's former credit card unit so KEB could absorb the unit at below-market prices. Lone Star has denied any wrongdoing.

In November 2006, the Seoul Central District Court approved prosecutors' requests to seek extraditions for Lone Star Vice Chairman Ellis Short and general counsel Michael Thomson in Yoo's case. Both have yet to travel to South Korea for questioning.

If Yoo and Lone Star were found guilty of the charges, the private equity fund would be forced to reduce its 51 percent stake in KEB to 10 percent within the next six months.

Grayken's arrival comes after HSBC (HSBA.L) (0005.HK) filed for regulatory approval in December for its $6.3 billion acquisition of Korea Exchange Bank (KEB) from Lone Star. They are aiming to close the deal by the end of April.

Regulators have said they can't start the approval process until all legal problems over Lone Star's purchase of KEB are resolved.

Lone Star's legal battles have been seen as a sign of discrimination against foreign investors in Korea after foreign funds had reaped huge profits from buying distressed Korean assets in the wake of the 1997-98 Asian financial crisis.

Analysts expect President-elect Lee Myung-bak, who has pledged to make the country more friendly to foreign investors, to help execute the HSBC-Lone Star transaction.

Shares in KEB dropped 1.4 percent to 14,100 won by 0238 GMT, underperforming the wider market's 0.45 percent rise.

(Reporting by Kim Yeon-hee; Editing by Sei Chong)