2.
<xsl:template match="para">

but now the output of the first paragraph looks like>
<p> <p> <b> Three words are </b> here </p> </p>

Also, in this case you probably want to match on the first text node of
the first para rather than the para itself as in

<xsl:template match="chapter/section[1]/para[1]//text()[1]" priority="1">

As you have it, you are doing string operations on the entire paragraph
text which means that any element markup within the paragraph will be
lost.