ENTITY datatype

From the spec.,
   The value space of ENTITY is the set of all strings that match the
NCName production
   in [Namespaces in XML] and have been declared as an unparsed entity
in a document
   type definition.

I have two questions regarding the above description:
  1.) Does this means DTD is still needed for Schema validataion?
  2.) "unparsed entities" referenced in a Schema file must be declared
in a DTD.
       Can this DTD be part of XML Schema internal subset?  Or, should
this DTD
       be part of instance document?

Thx,

-Stanley