1. No it doesn't - I have two WinXP installations on my machine, one on the C drive, and one on the H drive. I use the H drive version daily - the C drive is for beta testing the WinXP SP2 which has just gone into beta. It all works perfectly.
2. There's often confusion here. A FAT partition can't support a file size of more than 4 gigabytes - not much use if you're a video editor. NTFS partitions don't have that limit, and if you can't install more than 4Gb of software in WinXP I'm in big trouble - I have far more than that installed, and the computer runs like a dream.
3. Not really, although you can do it if you like - it will have some effect on disk fragmentation.
4. Yes, it's a good idea - particularly if you work with large image/video/sound files.