Is it OK to change the hostname of the virutal XP instance, is this going to break the "XP Mode" functionality?
It's ok to change the name.
Note that you'll need to change the saved logon credentials if you want to login as another user (like a domain user). This is done in the Virtual PC settings dialog for the XP Mode machine.
Some issues with networking could occur depending on the host configuration, requiring some further changes of the VM network settings to get it to successfully talk to domain controllers.