Exchanging links between several websites is called Link Exchange. Link can be there in any format. It can be a text link, HTML link with anchor text OR a banner link.
Why Link Exchange?

Main use of Link exchange is to increase the Search Engine Rankings. It is one of the method of Link Building.
How to do Link Exchange?

There are many ways to exchange the links between various websites but mainly 3 forms are very popular.

* One way Link Exchange
Generate a link from a website without giving a link in return from your website is called One way Link Exchange. From the Search Engine point of view, it’s the best Link Exchange option.
* Reciprocal Link Exchange
Exchanging links between 2 websites is called Reciprocal Link Exchange. You get a link from a website and give that website a link in return from you website in this method. This is not preferred method. Google hates Reciprocal Link Exchanges so try to avoid this method.
* Three way Link Exchange
Three way Link Exchange is basically a Reciprocal Link Exchange but it get implemented in different manner. Search Engine gives the very less importance to Reciprocal Link Exchange so main AIM of Three way Link Exchange is to fool Search Engines. There will be three websites in picture that exchanging links to each other but no Reciprocal manner. Website A will give link to Website B, Website B will give link to Website C and Website C will give link to Website A. So in this way, each website will get one backlink without doing Reciprocal Link Exchange.

But a good linking strategy is necessary to build link popularity – a measure of the popularity of a website based on the number of other website’s linking to it. And at the same time it has become very difficult to compete on the internet with websites that have 1000s of backlinks, sites that have their carefully chosen anchor text firmly in place. If you as a webmaster were to gain one new link to your site every day for one year you would only have 365 backlinks. Even with a more optimistic 2 links a day we are still only talking about 730 links. They may seem like a lot but in the real world of the internet and depending on the keywords you are competing for, you may need hundreds or even thousands more.

Because link popularity is the ultimate tool in achieving ranking. Link popularity is measured by the number and quality of inbound links to your site. The more you increase the link popularity of your web site, the probability of maintaining a higher search engine position for a longer period of time becomes more likely. Inbound links help to attain high search engine rankings for your web site, while producing traffic from visitors clicking through on the links themselves. So you have a dilemma. You need hundreds maybe even thousands of inbound links to your site. But how can one individual possibly achieve this goal given the numbers of backlinks needed and the hours it takes to accomplish such a task?

There is only one solution. A link exchange. The only effective way to get the sheer amount of backlinks needed to compete is to coop with other webmasters in a large group and share the wealth of pages that is owned by the group. It is similar to risk management. You utilized the power of large numbers of people. Link exchanges are sites that bring webmasters together to cooperate in the exchange of links for the benefit building both pagerank and link popularity. They are commonly used to gain link popularity which will increase ranking in search engines like Yahoo! or Google. Both of these engines use link popularity as a factor in calculating web pages ranking in the search engine results.

Be very careful to choose the correct anchor text when signing up to a link exchange. Anchor text is the text within the hyperlink. The major search engines look carefully at this text to help determine what your page is about. For example if there are 1000 pages linking to yours with the words “buy a car” then you will likely do very well when someone uses the search phrase “buy a car”. An example of the power of anchor text is what is known as a “Google bomb”. If enough sites link to a specific website with the same anchor text then that site will rank well for that term regardless of whether the keywords are even found on the page.