What Is APY?
APY (Annual Percentage Yield) is the effective annual return on an investment when compound interest is factored in — interest earning interest. It's always equal to or higher than the equivalent APR because compounding adds additional returns. In DeFi, APY assumes you reinvest (auto-compound) your earned rewards.
How APY Works
The formula: APY = (1 + APR/n)^n - 1, where n is the number of compounding periods per year. At 100% APR compounded daily (n=365), the APY is 171.5%. At extreme DeFi rates, the difference is dramatic: 1,000% APR compounded daily yields an APY above 2 million percent — which is why some protocols advertise eye-popping numbers.
Why It Matters for Traders
Extremely high APYs in DeFi are almost always unsustainable and often indicate high risk — either the underlying token is inflationary (you earn tokens that lose value), the yield is subsidized (venture capital burning money for user acquisition), or the protocol carries smart contract risk. Always evaluate the source of yield: if you can't identify where the returns come from, you're likely the exit liquidity.