The 27-year-old, who spent last term on loan at Everton, travelled to Wolverhampton for talks and a medical last week, and the paperwork for the Ecuador midfielder's transfer was completed over the weekend.
Wolves have an option to make the move permanent at the end of the loan spell.
"I'm very happy to be joining Wolves," he told the club's official website.
"It's another chance for me to prove myself in England.
"Hopefully after the internationals I will get quickly settled into the squad.
"I know Nenad (Milijas)very well and that makes it easier when you arrive at a new club that you know someone in the team.
"I've been at teams at the top of the table in Ecuador and then with Everton last season but I'm looking forward to the challenge of trying to help establish Wolves in the Premier League."
Wolves manager Mick McCarthy is thrilled to have secured Castillo's services.
"Segundo has good experience, having played in the Premier League for Everton and made 42 international appearances for Ecuador," he said.
"He also played for two seasons at Red Star Belgrade with Nenad.
"He will certainly add quality to the squad, and I'm delighted to have brought him in."
Castillo began his career in his homeland with Club Deportivo Espoli and then El Nacional, helping the latter clinch back-to-back titles in 2005 and 2006.
He proved a key player for Red Star as the Serbian outfit claimed a league-and-cup double in his debut season, and went on to score 18 goals in 72 appearances for the club before an injury-plagued stint on Merseyside last term.
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