Real Madrid loan Canales to Valencia
Valencia have the option the make the move permanent at the end of each season, which local media reported to be at a price of around 12 million euros.
Real have included a buy-back option should the 20-year-old continue at Valencia.
"It's a great club that is fighting at the top level every year nationally and internationally," Canales told the Valencia website.
"It's also an important step that will allow me to continue playing in the football elite."
Canales, who is representing Spain at the World Under-20 championship in Colombia, struggled to find a place in the Real first team after moving from Racing Santander on a six-year contract last year.
Valencia finished third behind Real in La Liga last May to qualify directly for the Champions League next season.