You install Virtual Machine software such as Vmware Workstion, Sun Virtual Box or Microsoft Virtual PC.
When you setup a new virtual machine, it will give you the option to create all the hardware including hard drive.
Some software such as Vmware Workstation allows you to use a physical hard drive as the virtual hard drive - however this is no requirement and you can easily just use a file on an existing hard drive (for example, VMDK is to a hard drive - what an iso is to a cd rom).
The virtual machine is a completely emulated (well almost) environment that has its own BIOS, hardware and operating system. You would install Windows or whatever OS you want in the same way as you would on a physical machine (only you can mount ISO files to optical drives in order to save time).
For example, on your own machine, if you had no operating system, it may say "opearting system not found"... The VM would do exactly the same.