Cryptocurrencies are mainly associated with volatility, which is a source of high risks and high returns. That is why many entering the crypto exchange seek assets with the highest potential returns. In most cases, the metric that can identify ROI (return on investment) is the annual percentage yield (APY). But is this an unshakeable truth? What other parameters affect the profitability of an asset and how should they be weighed to make wise investment decisions in crypto investing?

This article provides an in-depth answer to the question: 'How does APY work?' Read on to master the art of evaluating crypto projects like a professional investor.

What is APY?

So, the APY figure is the total amount of interest or rewards you can expect from the crypto project you're investing in. While it usually differs from the APR (annual percentage rate), it is a more realistic figure that accounts for compound interest. Thus, by considering APY, you can get a clear idea of how much you will earn on your investments over a given period.

How does APY work? In short, it's the annual percentage rate (APR) combined with the interest rate of compounding interest on the assets you have staked or delegated for yield farming.

How to calculate APY? We won’t bore you with complicated formulas at this stage; the only thing you need to remember is that when calculating APY, the number of compounding periods per year is taken into account, giving you a higher figure compared to the APR rate.

How to calculate APY?

Wondering how to calculate APY for your potential investments? To find out the APY of your assets, you need to determine how often earned rewards will be capitalized (added to the deposit). Some projects do this daily, while others credit rewards weekly or monthly. After that, you can calculate the APY with a high degree of accuracy and compare it with the project's official APY rates.

The universal formula for calculating APY is as follows: APY=(1+r/n)^n−1

You will need only two parameters here:

n = number of compounding periods per year

r = annual percentage rate (APR)

To simplify, let's look at how this works using the example of a USDT staking pool with an APR of 10% and a monthly compounding period. The formula for annual investment would look as follows:

APY = (1 + 0.10/12)^12 – 1 = 0.1047 or 10.47%

Thus, as you can see, the real APY is higher than 10% APR, as it accounts for reinvested interest. With this information at your disposal, you will certainly understand APY much better. If you are still wondering: 'How does APY work?', let's look at more specific examples of its application in the field of crypto investments.

Crypto rewards and yield farming

The most popular sources of high passive income for crypto investors are yield farming and liquidity pools. There's nothing simpler than buying some cryptocurrency and placing it in a yield farming pool for generous rewards. Some projects offer extremely attractive APYs reaching 100%+ to attract liquidity to new, high-risk projects.

However, with crypto rewards, it's not so simple; you need to understand all the nuances and dynamics of APY recalculation when participating in such pools. An unpleasant surprise might be that you can actually end up with a negative APY in such pools, meaning you will lose funds instead of earning them.

The biggest risk comes from impermanent loss — if one asset in the pair you sent to the liquidity pool appreciates in value, you could end up with fewer assets compared to your initial investments. Additionally, all crypto exchanges are vulnerable to hacks and exploits when criminals withdraw funds from liquidity pools. How the exchange handles such losses depends on the integrity of the management and the amount of loss; however, in most cases, users lose a significant portion of their funds due to irreversible cryptocurrency theft.

Market capitalization and trading volume

The market capitalization and trading volume of the project are vital parameters of its health and stability. Therefore, you should always pay attention to these parameters in conjunction with APY. What should you look out for?

Cryptocurrencies with a market capitalization of over $10 billion (e.g., $BTC , $ETH ) offer low-risk investment opportunities with low APY.

Mid-cap projects (e.g., $AVAX, $LINK, $SOL ) are projects with a market capitalization of $1 to $10 billion. They grow faster and come with a slightly higher risk for investors. However, their APY is higher than that of crypto giants.

Low-cap cryptocurrencies are those with a market capitalization of less than $1 billion. They generally offer the highest APY but are a risky investment due to the threat of fraud or manipulation.

In addition to market capitalization, you can also consider the 24-hour trading volume metric to see if there is active interest in the cryptocurrency you are interested in. Low trading volumes are more susceptible to manipulation by 'whales,' and the risk of price slippage can quickly deter investors from the project, thus putting your investments at risk.

Total value locked (TVL)

APY doesn't matter if you are investing in a fraudulent project. That's why you should conduct thorough due diligence before choosing cryptocurrencies for investment. The TVL metric can be a good assistant in this process, as it is one of the key parameters used to assess the amount of crypto assets invested in a project in the form of staking, lending, and liquidity pools.

The logic is simple: the higher the TVL, the more reliable the project. But what benchmarks can help you assess the adequacy of TVL, especially for small startup projects? Here are a few tips to consider:

Track TVL dynamics over time. A consistently growing TVL is a positive indicator of increasing awareness and trust in the project.

Evaluate the ratio of TVL to market capitalization, also known as the TVL ratio. A figure below 1.0 suggests that the project is undervalued, while a ratio above 1.5 might hint at its overvaluation.

Assessing TVL will also give you deeper insight into the potential profitability of investments in a project. A low TVL usually promises higher profits due to the higher risks associated, while a high TVL is accompanied by a lower APY due to the project's stability, low risk, and already high liquidity.

Fear and Greed Index

The Fear and Greed Index is another important indicator that can affect your APY. It's a macro indicator that assesses market sentiment on a scale from extreme fear (a sell-off characterized by panic and a complete lack of interest in buying assets) to extreme greed (euphoria accompanied by FOMO, pushing buyers to acquire assets at unrealistically high prices).

Key ranges to track before making any investment decisions:

0-24 points — Extreme fear.

25-49 points — Fear.

50-74 points — Greed.

75-100 points — Extreme greed.

The interpretation for investors is also quite simple; if fear reigns in the market, you can buy assets at significantly reduced prices and potentially profit. APY also tends to rise when the market is bearish and prices are low. If the market is in euphoria, it may be the optimal time to sell your assets and lock in profits.

Always weigh these indicators to make informed decisions.

As you can see, APY is indeed a vital parameter for calculating your potential profits from staking, lending, and yield farming. It is more accurate than APR as it accounts for compound interest, making it a reliable indicator of profitability. However, choosing an incredibly high APY by itself is an unreasonable strategy, as it often indicates a risky, fraudulent project rather than overwhelming profit. Therefore, it's essential to conduct your own research on each project you consider for investment, as well as assess the broader market landscape and conditions.