Is it possible to have three levels of subdomains in Drupal 7?
The answer is "yes". A Drupal multisite can use whatever structure it likes, including the one you propose.

To do this for subdomain http://fr.subset1.example.com/ just create the following subdrectory sites/fr.subset1.example.com/. Make sure it contains the file default.setttings.php and a copy this to settings.php. Then create subdirectories files  (and optionally, modules and themes), and make sure they're all writable by the web-server user. 

Then:


Set up DNS for this subdomain (fr.subset1.example.com) to point to the same IP as the default domain.
Create a serveralias (details below) (or vhost entry) for that directory that has the same web root as the default domain.
Point your browser to the base URL of your website (http://fr.subset1.example.com/) to complete the web based part of the installation of a Drupal site.


To create a multi-site instance, you also need to make sure the DNS for that instance points to the same web root as the default domain. If you've set up a sub-domain, the simplest way to do this is to add it as a ServerAlias. This means putting something like this in the Apache vhost configuration:

&lt;VirtualHost *&gt;
  ServerName example.com
  ServerAlias fr.example.com
  ServerAlias fr.subset1.example.com
  …
  DocumentRoot /var/www/example.com/htdocs/
  …
&lt;/VirtualHost *&gt;


Alternatively, you may create a separate vhost for the multi-site. This requires a separate entry, but allow you to tailor the web server settings for this particular multi-site instance.

Repeat this procedure for any other subdomains you want.