Yield Farming Chapter Six - APR vs APY
This is Chapter Six, focused on APR versus APR, in a series of articles that will be released about yield farming. The purpose of this series is to introduce the concept of yield farming to those who are unfamiliar with it, then move into various yield farming strategies and finally step-by-step walkthrough of the process. I hope you enjoy the series and any feedback you have would be greatly appreciated.
Chapter Six - APR vs APY
APR = Annual Percentage Rate
APY = Annual Percentage Yield
APR and APY both represent measurements of interest but are calculated differently and it is important to know the difference in calculating returns. he major difference in the two is when they are used and how compounding is calculated. It is important to understand how each works and be able to compare different returns expressed in one versus the other.
Compounding
Compound interest is the addition of interest on top of the principle sum or interest on principal plus interest. The result of reinvesting interest by adding it to the existing principal, is that the interest amount derived the next period is greater than the time before.
If you want to make money in financial markets it is really important to understand what compounding is. Don't take it from me, let's turn to what perhaps the smartest man to ever live had to say on the subject.
"Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it." - Albert Einstein
What Einstein is saying is that compound interest can work for you or against you. With stocks, many financial planners will work with an annual interest rate of 8-10%. But what if you could earn as much in a month or less as you can in a year with your principle? Yield farming offers the opportunity to earn very high yields that compound monthly, weekly or even daily. If you take nothing else from reading this, finish understanding how important compounding is to growing your money and find ways to maximize the power of compounding over time.
What is APR?
Annual Percentage Rage (APR) typically represents the amount charged for borrowing. It is the simpler calculation and better for situations that don't call for compounding. All things being equal, APR calculations will look smaller than APY calculations and that is why they are used more often when you are borrowing money and looking for the smallest possible rate.
APR = Periodic Rate x Number of Periods in a Year
What is APY?
Annual Percentage Yield (APY) typically represents the amount charged for loaning capital. The more complex calculation is better for situations that involve compounding. Since APY calculations take into account compounding, they are often used in yield farming which allows you to compound your gains and grow the underlying principle or gain interest on your interest. It also doesn't hurt that the returns look larger in APY terms and are more attractive to those staking or adding liquidity and getting APY returns.
APY = (1 + r/n)n – 1
r = annual interest rate
n = number of compounding periods each year
APR vs APY Example
Imagine you are investing $1,000 in a yield farm that earns 10% interest per month (120% annually) but you aren't sure if that is in APR vs APY terms. How might those returns look different?
APR
APR = 10% x 12 months = 120%, so in this case you will multiply your principal times your annual interest rate ($1,000 * 120%) to determine your interest and end up with $1,200 in interest and a total of $2,200 after a year.
APY
(1 + 0.1/12)^12 – 1 = 213.8428%, so in this case you will multiply your principal times the your compounding annual interest rate ($1,000 * 213.8428%) to determine your interest and end up with $2,138.43 in interest and a total of $3,138.43 after a year.
In this example you are only compounding once a month, however, in yield farms you compound much more frequently and likely once every day or two. Because you are compounding more frequently, the interest you earn on top of interest is much more significant.
There are many compounding calculators that can be found on the internet like the APY calculator provided by Calculate Stuff.
CoinGecko YouTube Video - APR vs APY
Previous Chapters
Yield Farming Chapter One - What is Yield Farming?
Yield Farming Chapter Two - Decentralized Finance
Yield Farming Chapter Three - Automated Market Maker
