Born in San Vicente, Zacapa, Guatemala, he emigrated to the United States in 1948 and studied under Wilfrid Sellars at the University of Minnesota, where he earned a B.A. in 1950 and M.A. in 1952. Castañeda received his Ph.D. in June 1954 for his dissertation "The Logical Structure of Moral Reasoning". He studied at Oxford University from 1955–1956, after which he once again returned to the US to take a sabbatical-replacement position in philosophy at Duke University. Castañeda is noted for his development of Guise theory, which he applied to outstanding problems in the analysis of thought, language, and the structure of the world. He is also credited with the discovery of the "quasi-indicator" or "quasi-indexical", a linguistic device by which one person can attribute an indexical reference to another. He died of a brain tumor in 1991.
Following his brief stay at Duke University, Castañeda's first full-time academic appointment was as a professor in the Philosophy department at Wayne State University, where he taught from 1957–1969. It was there that he founded the philosophical journal Noûs, in 1967. From 1962–1963, he was also a visiting professor at the University of Texas at Austin. He was granted a fellowship from the Guggenheim Foundation between 1967 and 1968.
He moved to Indiana University in 1969, and eventually became the Mahlon Powell Professor of Philosophy as well as that university's first Dean of Latino Affairs, a position he held from 1978–1981. He was a fellow at the Center for Advanced Study in the Behavioral Sciences from 1981–1982.
In addition to his other academic honors, Castañeda received grants from the National Endowment for the Humanities, the Andrew W. Mellon Foundation, and the National Science Foundation. He served as President of the American Philosophical Association Central Division from 1979–1980, and was named to the American Academy of Arts and Sciences in 1990. Castañeda was awarded the Presidential Medal of Honor by the Government of Guatemala in 1991.
Castañeda started from the fact that thoughts about real things in the world are of a fundamentally similar nature to thoughts about things in the imagination, it is still a thought, and from there he hypothesized an entire realm of abstract objects that included both the real and the imagined. He referred to these objects collectively as guises, and argued that they could be treated as sets of properties. He went on to analyse all of language and perception in terms of these guises, ultimately developing an entire metaphysics based on them.
One noted critic of Guise theory was Plantinga, who developed his own rival theory involving a realm of abstract objects. Both theories were in fact based on even earlier work developed by Ernst Mally in 1912. They differed, however, in the details of their metaphysical system and in how they regarded the basic building blocks of their respective systems.