Terminal Velocity is basically the speed in which you no longer increase in speed while falling. (or something like that. Since it is Velocity I am probably mistaken)
Small animals like bugs hit terminal velocity much sooner but never reach a speed in which they could possibly injure themselves.
Small animals like Cats and eagle chicks can still be killed by Terminal Velocity but actually have decent survival rates. (Cats reach terminal velocity at 6 stories but have a higher survival rate falling from even greater heights).
I don't believe there is currently a reason to do so (refering to knife)
Speed is everything in Dwarf Fortress. A Knife is not only faster then the Two hander but can also be weilded while carrying a good shield. Two handed weapons are at a distinct disadvantage.
Something should be said about the circumstances where being small is beneficial
Small Advantages:
-They are harder to spot and to be noticed.
-Their equipment is cheaper to produce.
-They eat less to survive
-They can travel inside creatures can slay them that way
-They can manuver more easily to locations where it is difficult-impossible to strike or grab them.
A small, agile attacker could very well dodge out of the way of a lumbering giant's attacks
The way it works logically is that it is harder for the Giant to strike its opponent but harder for the smaller opponent to dodge.
The difficulty to hit goes up dramatically with smaller creatures with thin weapons. Thick weapons such as hammers have no problem, Trying to stab an ant with a arrow will be somewhat difficult.