Sorry, I assumed you already had the CHD. To create a 500MB CHD file named hdd.chd in chdman, type the following command:
chdman -createblankhd hhd.chd 1015 16 63
From the error your getting, I'm assuming your chdman.exe file is in your MESS folder located at C:\MESS\.
You'll need to install MS-DOS in it before using it properly in winimage. You might have to set the boot sequence in the BIOS to a:,c:.
Once you've created your hdd.chd file, or if you already have an existing *.chd file that you want to convert to a *.raw file, type the following command to convert it to a hdd.raw file.
chdman -extract hhd.chd hdd.raw
It should open up in winimage now.
To set this up in the BIOS, just copy the screenshot.
I've tried creating a 1GB chd file, but the driver won't accept it properly and MS-DOS freaks out when trying to install on it. 750MB might work. It's possible now actually have two hard drives installed, so you get both c:\ and d:\. I'll probably just stick with that for now.