Virtual Hard Disks (VHD) are files on the physical machine that store the hard disk contents of a Virtual Machine (VM). Each VHD is treated as a separate hard disk by Windows Virtual PC (WVPC), Windows XP Mode, Microsoft Hyper-V, Virtual PC 2007 and other Microsoft’s virtualization solutions. There’re three types of Virtual Hard Disks: fixed disks, dynamically expanding disks and differencing disks. All VHDs have “.vhd” extension, and maximum size of a VHDs supported by WVPC is 127GB. Dynamically expanding disks and differencing disks’re by far most commonly used VHD types. The biggest advantage of differencing disks is that you can’ve as many child disks as you like from a single parent disk. So if you need 5 vms with Windows XP with each configured differently, you can simply create a single sparse/fixed VHD with XP installed on it and then create 5 differencing disks from this. So that’s saving 4 times the space needed to install Windows XP!
Full Article: WVPC blog