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Set up blog hosted on different host name but same domain, blog.mysite.com. Obvious benefits would be links are now considered IBL from an external site, since bots will view blog
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You don't need to host the subdomain on a separate web host--hosting it on the same host as the main domain is perfectly fine and you'll get the same benefits of the links. If you're going to get separate hosting, it would be preferred that you host the blog on a separate domain entirely, such as mysiteblog.com.
I don't recommend hosting a blog on another site like blogger or blogspot. You don't have as much control over the "back end" of the blog. So much of the "optimizing" of the blog comes when you edit the template of the blog, edit the permalinks and how they're displayed, and the pings that are sent out when you post in your blog.