The elven merchant is more focused on bows, but can also have swords (and mithril armour, good for mages since it has a high armour value and low strength requirement).
That frost sword was a random drop. Stats are random even on items that are always in the game (the bat of striking and amulet of glory in the catacombs, dragon armour pieces, etc) or with opponents that always drop something when defeated.
The dwarven halls are in the mountains on the western side of the dark forest.
west of the warrior's guild
If you wait until you are done the quests in the dark forest (the ghost 'only' kills the travellers that are looking for a vase and the elves, other than the elven council member), you can take and keep the sword in the stone. You can also cheat to duplicate the sword and put one copy back.
To copy an item; quick save the game, then drag an item out of your inventory, but not somewhere there is a red X. Without dropping first, quick load the game, then release the mouse button when it starts to load. This will produce a copy of the item on the ground, with the original still in your inventory.
