Understanding Yield: APY, APR, and How DeFi Returns Are Calculated

DeFi protocols display APY and APR figures that can range from 3% to 3,000,000%. Understanding how these are calculated — and how they can be misleading — is essential for evaluating whether a yield opportunity is real.

APR vs APY

APR (Annual Percentage Rate) is the simple interest rate — what you earn without reinvesting. APY (Annual Percentage Yield) compounds interest — assumes you reinvest earnings continuously. A 12% APR compounded monthly becomes 12.68% APY. The more frequent the compounding, the larger the difference. Protocols that want to look impressive display APY; protocols being conservative display APR.

How Protocol Yields Are Calculated

Lending yields: interest rate × utilization rate × (1 - reserve factor). At 80% utilization with a 10% borrow rate and 10% reserve: 80% × 10% × 90% = 7.2% supply APY. Trading fee yields: 24-hour fee volume ÷ total liquidity × 365. Emission yields: (tokens emitted per year × token price) ÷ total liquidity. The last one is particularly important to understand.

The Emission APY Problem

Many high APY figures in DeFi are emission-funded — the protocol is printing tokens and distributing them to liquidity providers. If the token price drops, the APY collapses. If everyone tries to harvest and sell the emissions, the token price drops, creating a death spiral. A 200% APY funded by token emissions is often unsustainable; a 5% APY from real trading fees is genuine yield.

Impermanent Loss Impact on Yield

AMM LPs earn trading fees — but this is net of impermanent loss. A pool showing 20% APY in fees might produce a net negative return if impermanent loss from price divergence exceeds fee income. Always evaluate fee APY alongside the expected price correlation/volatility of the pair. Stablecoin pairs have minimal IL risk; volatile pairs have significant IL risk.

Real vs Nominal Yield

If your yield is paid in a token that's inflating, your real yield is lower. If you earn 50% APY in a governance token that loses 60% of its value over the year, your net return is negative in dollar terms. Always ask: what currency is the yield paid in? What's the emission rate and inflation of that token? Can you hedge the yield token?

Evaluating a Yield Opportunity

Questions to ask: Is the yield from real fees or token emissions? If token emissions, what's the emission rate and token inflation? Is the pool audited and battle-tested? Is there impermanent loss risk? Can I exit immediately or is there a lockup? Who is the counterparty risk (the smart contract, the protocol governance, the underlying assets)? High advertised APY is almost always a signal that something — IL risk, emission inflation, smart contract risk, or liquidity risk — is being obscured.