To create a soft focus effect on the larger background image, I duplicated the Background layer, and using the Filter menu, applied a Gaussian Blur of 10, and then lowered the opacity of the blurry layer to 70%.
Variation 1: Gaussian Blur applied to background
Here I made a selection based on the smaller photo by Command-clicking (PC: Control-clicking) on its thumbnail in the Layers palette, then adding a layer on which I created a stroke (using Edit>Stroke). Then, I applied a filter to the stroke layer. (See Technique #14 for the steps to apply a filter to a stroke.)
Variation 2: Filter applied to stroke
In this example, I scaled the smaller photo, added the Hue/Saturation adjustment layer, and then added a Drop Shadow layer style that I positioned as more of a slight outer glow.
Variation 3: Stroke replaced with drop shadow