Simply put proxydhcp is using a separate dhcp from the regular dhcp server to hand out boot parameters. An existing dhcp server isn't modified. Very handy for setting up a PXE environment without access to the existing dhcp infrastructure. Ubuntu community docs mention that dnsmasq 2.48 or newer supports being a proxydhcp server and that gpxe newer than may 2009 is also needed (gPXE version 0.9.8?). Those docs also mention that proprietary bootroms can also support proxydhcp, so chainloaders aren't left out.

Note: dnsmasq 0.52 and newer requires gpxe 1.0.0 or newer. Most likely standards related as Intel UNDI code didn't flinch between dnsmasq versions 0.51 and 0.52.

Further reading

Proxy DHCP section on wikipedia

very minimal configuration for dnsmasq

#set port to 0 so that dnsmasq knows its not being used as a dns server
# This line mentions "pxelinux" which by spec would boot pxelinux.0
# doesn't get sent out in packets so this is a trigger
pxe-service=123456789, "Install Linux", pxelinux,0


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