What command are you using to run Xephyr? I use
Xephyr -br -ac -noreset -screen 640x480 :1 &, but replace 640x480 witch whatever resolution you need. Then you can run your wm with
env DISPLAY=:1 opnebox (or whatever your wm might be). You are running xephyr inside of an X session, right?
That doesn't make sense. xinit/startx set DISPLAY, so there should never be a reason to set it manually.