What Is APY In Crypto And How Do You Calculate It?
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Continuing our series of blogs focused on the DeFi space, we’re answering the question “what is APY in crypto and how do you calculate it?”
We’re the first to admit there’s a lot of terminology when it comes to crypto (acronyms aplenty, too). Indeed, we’ve previously written a guide to some commonly-used crypto jargon.
APY isn’t just a crypto-specific term – it crosses over from traditional finance, but is particularly important to crypto holders seeking to measure and compare the potential benefit from an investment.
And in spite of a recent downturn in the crypto market, many consider the potential returns on crypto investment to be worth the risk of volatility in light of low returns on traditional financial products.
Let’s look more closely at what APY is in crypto and how it is calculated.
What is APY in crypto?
APY stands for annual percentage yield and it works the same way in crypto as in traditional finance.
APY refers to the return on an investment taking into account compound interest, as opposed to a simple interest rate which only represents the interest earned on the original stake.
Compound interest grows with the investment: you earn on your initial deposit, and then you earn additional interest on that interest.
A pretty good cycle, right?
APY is used in order to measure the return of such an investment over a period of a year.
It takes into account the frequency with which compounding occurs.
An investment that compounds more often will see a faster return on investment because the initial deposit increases in value more quickly, and subsequent interest payments are calculated on this larger amount.
Any investor wants to know whether they’re going to get a good return on their deposit and by using an APY measure, one can more easily compare returns across different investments with different compounding periods in order to make the best possible choice.
Annual percentage yield (APY) versus annual percentage rate (APR)
APY and APR should be taken into account together when making an investment.
APR is used to calculate the percentage amount paid over a year in interest and fees but does not take into account compound interest.
This is important, as APY calculations do not incorporate fees which need to be subtracted to give an accurate return on investment.
Therefore, when used in parallel, investors can get a more precise picture of the value of their investment.
How to calculate APY in crypto
As we have mentioned, noting the frequency of compounding periods is important when calculating APY in crypto.
The below formula can be used to work out APY on an investment:
APY = (1 + APR/n)ⁿ − 1
In this equation, “n” refers to the number of compounding periods each year.
There are some other factors worth considering when calculating APY.
It’s worth keeping an eye on inflation. If you invest in a cryptocurrency which is then hit by inflation rates that surpass your APY, your earnings are being lost just as quickly as they’re gained.
Supply and demand are also important when it comes to crypto APY, which will vary depending on the amount of demand (as well as liquidity) that a particular cryptocurrency has.
Crypto investments that earn APY
While some crypto HODLers will look to simply hang onto their coins and enjoy the upside potential, others will actively use their cryptocurrency to gain greater returns.
One investment route is staking. Stakers delegate a set amount of their crypto assets to lock up and take out of circulation for a predefined period of time.
This impacts supply, which in turn impacts value.
Another option is yield farming, which involves lending out your crypto assets to others.
Yield farmers move their crypto assets from marketplace to marketplace depending on the potential return.
To be a successful yield farmer, it is vital to constantly track APY in order to identify the most valuable opportunities.
Conclusion: what is APY in crypto and how do you calculate it?
To recap, APY reflects how much return there will be on an investment over the course of a year, taking into account compounding interest.
It’s vital to note the frequency of the compounding periods as this is a key part of the equation for calculating APY.
If you want to review your crypto investments with an experienced UK crypto accountant, you are in safe hands with Howlader and Co.
Get in touch today for a no-obligation chat with one of our in-house crypto accounting specialists.