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Run Disk Utility

That.

Or, in the Windows VM: click Start Menu -> right click Computer -> click Manage

When Computer Management has loaded, select Disk Management from the left pane (should be second from the bottom). On the bottom half of the window you should see a graphical representation of the partitions. Right click the partition you want to format, click Format, etc.

Disk Management is the Windows equivalent of OS X Disk Utility, use whichever you find easier to use.
 
Which one is better?
It depends.

FAT32 is supported practically everywhere, but has a file size limit of 4GB.
exFAT does not have that limitation, but might not be supported with some devices (DVRs, TVs, Macs with OS X older than 10.6.5, etc).

To format it, do you have to go to Erase, choose ExFat, and click Erase?

Most likely. Depends what are you erasing it with.
 
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