Reverse Exchangeable Securities (RES) issued by ABN AMRO bank are traded on the American Stock Exchange (AMEX). RES are a hybrid instrument and have a payoff that consists of a fixed amount and/or a payoff that is indexed to the performance of a highly liquid stock. Consider the RES that is described in the attached prospectus. The RES matures in one and a half years (the exact issue and maturity dates are given in the prospectus). The RES pays a coupon of 12%.

The payoff on the RES is determined by the value of 38.88 (let this be denoted by N) shares of Dell. If the price of Dell stock is greater than $25.72 (let this be denoted by K), then the final maturity value is equal to $1,000. If the price of Dell stock is less than $25.72, the final payoff is equal to 38.88 *Dell's Price/share, i.e. the bond is exchanged for 38.88 (N) shares.

Note that the number of shares of Dell multiplied by the benchmark price for Dell that triggers the differential payoff is equal to $1,000, (i.e. N*K = 1,000).

a. Break up the final payoff of the RES into a bond and an option and describe how you would value the security.